Best Funds for Rough Seas

It's brutal out there. We're in the second bear market of the decade. The banking system is a colossal mess. The economy is now almost certainly in recession.

The world doesn't end too often, so this too shall eventually pass. But 2009 will not be a strong year for the economy, and the uncharted waters of a shattered financial system only compound the uncertainty. So we are extra cautious in this unfriendly environment in recommending any mutual fund. Only those that do a good job of preserving shareholders' wealth were even considered. These five look especially compelling for the stressful year ahead.

Farsighted. For this year to October 13, Hussman Strategic Growth (symbol HSGFX) lost 4%, a whopping 33 percentage points less than Standard & Poor's 500-stock index. Clearly, this is no ordinary fund. John Hussman runs it kind of like a poor manUs hedge fund, owning stocks the traditional way but also short selling stocks and indexes to reduce exposure to risk.

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Hussman, who holds a doctorate in economics from Stanford University, says that since he launched Strategic Growth in July 2000, he's found the market too richly valued. So heUs consistently hedged his long positions in individual stocks by putting on short positions that range from 30% to 100% of his longs. From its inception to October 13, the fund returned an annualized 10%, compared with the S&P 500's decline of 4% a year. So far, the fund hasn't had a down year. Annual expenses run 1.11%.

The fund's performance has been aided by Hussman's remarkably clear-eyed and early view of the growing risks to the nation's financial system. In a July 2003 essay titled "Freight Trains and Steep Curves," he warned of the dangers to homeowners and corporations of snowballing adjustable-rate debt and dependence on low short-term interest rates. He predicted that the "unwinding of extreme leverage" would leave the U.S. economy vulnerable to an Racceleration of defaultsS and a debt crisis.

So it's no surprise that Hussman has avoided financial stocks completely. Instead, his fund has large positions in consumer-goods companies with predictable cash flows, such as Coca-Cola, Colgate-Palmolive and Johnson & Johnson. Hussman anticipates three to four more rocky quarters for the economy, but he says that the stock market is approaching fair value for the first time this decade.

If the market shoots up, this fund will likely trail. But over a full cycle of bull and bear markets, it has shown its worth as a portfolio diversifier.

Through think and thin. None of the dynamic thinking and economic analysis that Hussman brings to bear on his fund is to be found in Permanent Portfolio (PRPFX). Instead, this well-diversified fund is rather static in its allocations. It's almost on autopilot.

The fund's simple formula works. Since its inception 26 years ago, Permanent Portfolio has had only three down years (although it is down 11% to October 13, so this year could be the fourth). In the ten years through September 30, Permanent Portfolio returned 9% annualized.

Michael Cuggino, manager of the fund since 1991, divides the money into six asset classes: precious metals, Swiss francs, global real estate stocks, natural-resources stocks, domestic growth stocks and U.S. bonds. The idea is to preserve capital and provide low-risk growth through diversification into assets that tend not to move in sync with one another. For example, when inflation rears its head, gold and Swiss francs perform well; in deflation, U.S. Treasury securities kick in.

Permanent Portfolio places investors in a position to profit from a variety of economic scenarios and outcomes. "The premise is that the future is unpredictable," says Cuggino. Interestingly, the fund was launched in 1982 in response to turmoil because of inflation, high oil prices, decline of the dollar and miserable stock markets. Sound familiar? "No investments were performing," recalls Cuggino. "Investors felt as if they were losing even if they did nothing but sit on cash."

Like Hussman Strategic, Permanent Portfolio requires a low minimum investment of $1,000. The annual fee is 0.95%.

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Hunkered down. Value maven Steve Romick doesn't mind being called paranoid and neurotic. When you fret constantly about preservation of shareholders' capital, it comes with the territory. "I look down first before I jump," he says. Romick's finely honed sense of risk management shines through in the results of his idiosyncratic fund, FPA Crescent (FPACX).

Although the fund has lost 20% this year, it returned 10% annualized in the ten years through September 30. That's an average of four percentage points per year better than the typical balanced fund. Romick's goal is to provide stock-market-like rates of return with less risk than the market, and FPA Crescent has delivered in spades. Since launching the fund in 1993, Romick's only other down year was, ironically, 1999, at the height of the tech bubble.

Romick makes the most of his flexible investing mandate. To dampen volatility, heUs able to sell stocks short, and he does so when he spots significant balance-sheet and financial-leverage risks. That's what led him to short Lehman Brothers and Wachovia early this year. Like Hussman, Romick spied enormous risks building in the financial system in 2003, and he stopped investing in the stocks of lenders; he began shorting financials in 2005. At last report, his biggest long positions included ConocoPhillips, Ensco International and Assurant.

Unlike a typical balanced fund, FPA Crescent can roam across the capital structure of companiesQinvesting, for example, in preferred shares and convertible bonds, as well as common stock and corporate debt. Romick reckons that U.S. stocks will return only 4% to 8% annualized over the next decade, so he's looking for better value in high-yield debt and convertibles. Romick stresses that with bonds, "all you need to know is that the company can pay you back."

Shy of banks. Bruce Berkowitz and his team at Fairholme (FAIRX) fund also do a fine job of protecting shareholder capital through disciplined value investing, but they do so without the diverse armory of investment weapons that FPA Crescent deploys. Since its inception in December 1999 through September 30, this member of the Kiplinger 25 has returned 15% annualized. That compares with P1% a year for the S&P 500. In todayUs unforgiving market, Fairholme shed 28% to October 13, beating the S&P 500 by nine percentage points.

Unlike many less adroit value investors, Berkowitz steered clear of bank stocks no matter how cheap they looked on paper. He reasoned that the items both on and off their balance sheets were too complicated and, therefore, too fraught with risk. He also questioned how banks' funding sources and counterparties would react in a crisis.

In recent months, Berkowitz has invested aggressively in health-care stocks, such as Pfizer and Wellcare Health Plans. In picking stocks, he focuses on free-cash-flow yields (the amount of free cash a company generates divided by its stock-market value); the double-digit free-cash-flow yields of beaten-down drug and health-insurance stocks were enticing. Says Berkowitz, son of a grocery-store owner, "At the end of the day, cash is the only thing you can spend." Fairholme's annual expense ratio is 1%.

Healthy choice. The health-care sector is a classic haven for investors during an economic downturn. People get sick and have to take their medicine no matter what. Plus, the steady aging of society stimulates demand for therapeutic products and services.

T. Rowe Price Health Sciences (PRHSX) has a history of delivering healthy returns. Over the past five years, the fund, which invests in companies of all sizes, returned an annualized 4%, six percentage points better than a basket of health-care funds.

Kris Jenner, a medical doctor by training, runs this research-intensive fund (he has three doctors and three financial analysts on his staff) in an unusual way. Much of the effort goes into identifying small companies with the potential to launch truly cutting-edge drugs and technologies. He allocates 35% of the fund to biotechnology stocks, including his largest position, Gilead Sciences, a big winner in HIV therapies.

Sector funds are inherently volatile, so to dampen volatility Jenner also holds large, more predictable companies, such as Baxter International, CVS Caremark and Stryker. All in all, he's finding plenty of attractively valued companies in his bailiwick. "Stocks are getting bombed left and right, but the growth prospects of most of these companies haven't changed," he says. The fund's annual fee is 0.83%.