Hybrid Funds Promise Stabler Returns Investment Companies Tout `Balanced' and `Asset Allocation' Funds for Those Times When Market Is All Ups and Downs

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WITH stock and bond markets plummeting one day and surging the next, many small-time investors are scratching their heads. Should they reduce their exposure to stocks or bonds, or hang in there and ride out the rough times?

One way to try to do a little of both without mental anguish is to invest in hybrid mutual funds that blend stocks, bonds, and cash in one investment package.

Among funds where managers can move flexibly between stocks and bonds, a variety called asset-allocation funds has grown increasingly popular over the last couple of years. Asset allocation involves trying to find the optimum mix of different types of investments, often using statistical formulas to assess current markets. In another class of hybrid fund, balanced funds, managers rarely shift from a 60-40 blend of stocks and bonds. Together, balanced funds and flexible-blend funds account for about 12 percent of the $770 billion that Americans have invested in equity-holding mutual funds.

"Both of these categories have been significantly less volatile than the stock market," says Amy Arnott, an analyst with Morningstar Inc., a Chicago company that rates funds. But both categories have failed to beat Standard & Poor's corporation's widely used index of 500 stocks, suggesting that long-term investors who can afford to endure short-term fluctuation in their investments would do better with heavier exposure to stocks.

With $32 billion invested in them, asset-allocation funds lag behind balanced funds, which have $58 billion in assets. But the former group has come on strong, going from only four funds 10 years ago to 75 today. Balanced funds have grown more in line with the rest of the industry, with the number quadrupling to more than 100 in the last decade.

Boston-based Fidelity Investments, the nation's largest fund company, saw its Asset Manager fund and its balanced fund both roughly triple in assets last year, to $9 billion and $4.7 billion, respectively.

The asset-allocation idea is "finally getting the due it deserves," says Jeremy Duffield, a senior vice president at the Vanguard family of mutual funds, in Philadelphia. Like Fidelity's balanced and asset-allocation funds, Vanguard's hybrid funds in those categories have roughly matched the return of the S&P 500 despite their diversified approach.

Flexible funds are for "anybody who wants a diversified asset pool with somebody calling the shots," Mr. Duffield says. When markets are fluctuating, "that's where many individual investors get into trouble. They let their emotions rule their decisions."

Instead, Vanguard's asset-allocation fund is guided by a "decision framework" created by William Fouse, whose San Francisco company Mellon Capital Management runs the Vanguard fund. Mr. Fouse says his model, which looks at the expected risk-adjusted returns for different investments, will do a far better job than an individual investor.

The Vanguard fund, now with $1 billion in assets, fell much less than the overall stock market in a 1990 drop. Though the fund did not exist until 1988, Fouse says his model would have had most assets out of stocks prior to the crashes of 1973 and 1987, even though typically 60 percent of the fund's assets are in stocks.

This year, the Vanguard fund and most peers have been hit by a simultaneous drop in bonds and stocks. …