The herd instinct kicks into overdrive when mutual fund investors hear the word recession and news reports show stock prices dropping. Fears of further declines and mounting losses chase investors out of stock funds and push them toward bond funds in a flight to safety. It's an effective tactic for investors who are seeking to avoid risk and are smart or lucky enough to sell while their portfolios are still on the positive side - but it's not the only strategy available to combat tough times. Read on for a look at bond funds that tend to outperform in tough market conditions. (For background reading, see A Brief History Of The Mutual Fund.)

Tutorial: Mutual Fund Tutorial

1. Federal Government Bond Funds
There are several types of bond funds that are particularly popular with risk-averse investors. Funds made up of U.S. Treasury bonds lead the pack, as they are considered to be one of the safest. Investors face no credit risk because the government's ability to levy taxes and print money eliminates the risk of default and provides principal protection.

Bond funds that invest in mortgages securitized by the Government National Mortgage Association (Ginnie Mae) are also backed by the full faith and credit of the U.S. government. Most of the mortgages (typically mortgages for first-time homebuyers and low-income borrowers) securitized as Ginnie Mae mortgage-backed securities (MBS) are those guaranteed by the Federal Housing Administration (FHA), Veterans Affairs or other federal housing agencies.

2. Municipal Bond Funds
Next on the list are
municipal bond funds. Issued by state and local governments, these investments leverage local taxing authority to provide a high degree of safety and security to investors. They carry a greater risk than funds that invest in securities backed by the federal government, but are still considered to be relatively safe.

3. Taxable Corporate Bond Funds
Taxable bond funds issued by corporations are also a consideration. They offer higher yields than government-backed issues, but carry significantly more risk. Choosing a fund that invests in high-quality bond issues will help lower your risk. (Corporate Bonds: An Introduction To Credit Risk provides information about how to evaluate the risks or investing in corporate bonds.)

While corporate bond funds are riskier than funds that only hold government issued bonds, they are still less risky than stock funds. (Evaluating Bond Funds: Keeping It Simple provides an overview of some of the key factors for determining a fund's risk-return profile and Bond Funds Boost Income, Reduce Risk highlights the stable returns these investments can provide.)

4. Money Market Funds
When it comes to avoiding recessions, bonds are certainly popular, but they aren't the only game in town. Ultra-conservative investors and unsophisticated investors often stash their cash in money market funds. While these funds do provide a high degree of safety, they should only be used for short-term investment. (To learn more, read Introduction To Money Market Mutual Funds.)

5. Dividend Funds
Contrary to popular belief, seeking shelter during tough times doesn't necessarily mean abandoning the stock market altogether. While investors stereotypically think of the stock market as a vehicle for growth, share price appreciation isn't the only game in town when it comes to making money in the stock market. For example, mutual funds that focus on dividends can provide strong returns with less volatility than funds that focus strictly on growth. (To learn more about dividends, see Dividends Still Look Good After All These Years.)

6. Utilities-Based Mutual Funds
Utilities-based mutual funds
and funds that invest in consumer staples are less aggressive stock fund strategies that tend to focus on investing in companies that pay predictable dividends.

7. Large-Cap Funds
Traditionally, funds that invest in large-cap stocks tend to be less vulnerable than those that invest in small-cap stocks, as larger companies are generally better positioned to endure tough times. Shifting assets from funds that invest in smaller, more aggressive companies to those that bet on blue chips provides a way to cushion your portfolio against market declines without fleeing the stock market altogether.

8. Hedge Funds and Foul Weather Funds
For wealthier individuals, investing a portion of your portfolio in hedge funds is one idea. Hedge funds are designed to make money regardless of market conditions. Investing in a foul weather fund is another idea, as these funds are specifically designed to make money when the markets are in decline.

In both cases, these funds should only represent a small percentage of your total holdings. In the case of hedge funds, "hedging" is actually the practice of attempting to reduce risk, but the actual goal of most hedge funds today is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Hedge funds typically use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. In the case of foul weather funds, your portfolio may not fare well when times are good.

Diversification: A Strategy for Any Market
While bond funds and similarly conservative investments have shown their value as safe havens during tough times, investing like a lemming isn't the right strategy for investors seeking long-term growth. Trying to time the market by selling your stock funds before they lose money and using the proceeds to buy bond funds or other conservative investments and then doing the reverse just in time to capture the profits when the stock market rises is a risky game to play. The odds of making the right move are stacked against you. Even if you achieve success once, the odds of repeating that win over and over again throughout a lifetime of investing simply aren't in your favor.

A far better strategy is to build a diversified mutual fund portfolio. A properly constructed portfolio, including a mix of both stock and bonds funds, provides an opportunity to participate in stock market growth and cushions your portfolio when the stock market is in decline. Such a portfolio can be constructed by purchasing individual funds in proportions that match your desired asset allocation. Alternatively, you can do the entire job with a single fund by purchasing a mutual fund that has "growth and income" or "balanced" in its name. (To learn more, read Managing A Portfolio Of Mutual Funds.)

Regardless of where you put your money, if you have a long-term time frame, look at a down market as an opportunity to buy. Instead of selling when the price is low, look at is an opportunity to build your portfolio at a discount. When retirement becomes a near-term possibility, make a permanent move in a conservative direction. Do it because you have enough money to meet your needs and want to remove some of the risk from your portfolio for good, not because you plan to jump back in when you think the markets will rise again.

Related Articles
  1. Professionals

    10 Must Watch Documentaries For Finance Professionals

    Find out about some of the best documentaries that finance professionals can watch to gain a better understanding of their industry.
  2. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  3. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  4. Professionals

    Tax Efficient Strategies for Mutual Funds

    Before you sell mutual fund shares, consider these tax strategies first.
  5. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  6. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  7. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  8. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  9. Investing Basics

    Diversifying Your Portfolio: 5 Easy Steps

    You can never be sure of what the market will do at any given moment. That’s why a well-diversified portfolio is so important.
  10. Mutual Funds & ETFs

    Is Your Financial Advisor Picking the Right Mutual Funds?

    Learn about the different types of mutual funds and how to know if your financial advisor is choosing the right funds for you based on your investment goals.
  1. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  2. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  3. Do financial advisors get paid by mutual funds?

    Financial advisors are reimbursed by mutual funds in exchange for the investment and financial advice they provide. A financial ... Read Full Answer >>
  4. Why is fiduciary duty so important?

    Fiduciary duty is one the most important professional obligations. It basically provides a much-needed protection for individuals ... Read Full Answer >>
  5. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  6. Why do financial advisors have a fiduciary responsibility?

    Financial advisors governed by fiduciary duty are bound by law to act in the best interests of their clients at all times. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!