Family & Home: Short-Term Investments

The Best Short-Term Investments
By SmartMoney.com Staff

DURING THE 2000-2002 bear market (which is not easily forgotten, despite the solid returns seen in 2003 and 2004) even the most adventurous investors learned to appreciate the buoyancy of low-risk funds. Sure, these cautious portfolios are unlikely to offer fabulous 20% annualized returns during even the best of times. But risk-averse fund managers are just the kind of people you want managing your money when things aren't so rosy or when you know you're going to redeem your fund shares in the next couple of years.

That's not to say you want managers who are so paralyzed with fear that they run their portfolios like money-market funds. And you definitely don't want managers who are trailing the market because of their own incompetence, rather than their aversion to risk. The key is to separate the intelligently cautious from the totally clueless.

See these sections below:

• Low-Risk Stock Funds
• Bonds and Bond Funds
• Loan-Participation Funds

Low-Risk Stock Funds

That was the guiding principle behind our low-risk stock-fund picks. (Click here for a list of the specific funds we recommend). To find them, our fund-screening system ranked funds based on their three-year returns, with an eye to their volatility as measured by the standard deviation of their monthly returns over the past three years. This means we penalized the funds that topped the charts one month but tumbled the next.

The screen also punished funds with sales charges (i.e., loads -- a real rip-off if you're only going to hold these funds for a few years), high turnover and above-average expenses. Ultimately, we selected the least-risky funds, cutting those with a minimum-investment requirement over $5,000, since it would be hard for many people to buy the three or more funds they need for a diversified portfolio if the minimums were that steep.

Bonds and Bond Funds

As boring as they may be, you can't ignore bonds in a safe-investment portfolio. They may not soar like stocks, but they won't crash and burn, either.

If you're willing to put in the effort, you're better off buying individual bonds instead of bond funds. You can tailor a portfolio of bonds to meet your circumstances, meaning the bonds will mature precisely when you need the funds. And by holding bonds to maturity, you eliminate the risk that rising interest rates will cut into your investment.

When it comes to individual bonds, we like Treasury strips, which are easy to buy and sell, and offer guaranteed returns if you hold them to maturity. Strips are created by the big Wall Street bond houses, which clip interest-bearing coupons from long-term Treasury bonds. The strips are essentially zero-coupon bonds, meaning you buy them through your broker at a discount to face value -- say $4,200 for a $5,000 bond -- and you get the full value at maturity with no interest payments in between . Strips are generally purchased at a face-value minimum of $5,000, though some brokers will sell them in smaller denominations.

When putting together a portfolio of strips, it can be wise to buy strips with different maturities. This creates a laddered portfolio, which can be a way to reduce risk and boost returns. You get more yield on the longer maturities, but your risk is tempered by the shorter-term bonds.

If interest rates rise, you'll lose money on your longer-term bonds, but you'll most likely make it back when you buy new bonds at the higher rate using the proceeds from your maturing bonds. The big discount brokers like Schwab and Fidelity offer laddered portfolios of strips with three maturities, and their quoted yields include the commission. Fidelity, for example, charges $150 for a ladder of three bonds, although you can pay less by using one of the deep-discount brokers.

If all this talk about maturities and interest rates is too much to deal with, you should probably buy a bond fund. Bond funds are slightly different animals than individual bonds, since they offer no maturity date. This means you can't tailor your investment in a bond fund to match up perfectly with your short-term goal. That said, the funds we recommend (click here for specific picks) are so tame and so much easier to deal with than individual bonds, this trade-off is probably worth it. You also can get started with a lot less cash than would be required to create your own bond portfolio.

To find our picks, we focused on three-year returns, high credit quality and low expenses. The latter is particularly important, as high fees can rapidly erode bond-fund returns. The funds also had to be no-load with minimum initial investment requirements of $5,000 or less.

Loan-Participation Funds

Loan-participation funds -- also known as bank-loan funds, floating-rate funds or prime-rate funds -- once represented a relatively small (and largely undiscovered) sector of the investing world. But the healthy long-term returns of this small group have prompted an increasing number of firms to roll out offerings, and this competition has been driving down fees and increasing options.

Loan-participation funds invest in loans that are made by banks to companies with low credit ratings. That means the risk of default is higher, but the income, or interest rate, from the loan is also higher to help compensate for that risk. Now, if you were owed a single loan, the risk wouldn't be worth it. But the fund manager's job is to invest in enough of these loans that the blended risk is minimized. Also, since these loans are considered senior secured debt, they are the first loans that are paid off if a company goes bankrupt. That means the lenders typically recover about 75% of any defaulted loans.

The results for investors have been good, especially when you consider that loan-participation funds balance out our short-term-bond selections, since each fund type thrives during different parts of the economic cycle. When the economy is humming and the Fed raises interest rates, bond funds suffer, but the yield on loan-participation funds rises. For example, during the bull market of 1994 through 1998, loan-participation funds delivered more than 7% a year on average, while short-term-bond funds gained 5.5% annualized. And in 2004 -- when the economy continued its recovery and interest rates were hiked five times (each time by a quarter point) -- this group gained 3.7% compared with bond funds' 1.1% gain.

But when a bear market sets in, these fund groups can trade places. In 2002, for example (when the S&P 500 plunged 22%), loan-participation funds returned 2.2% on average, while short-term U.S. government funds had average returns of 7.3%. The reason why loan-participation funds tend to perform poorly during bearish times is because the loans these funds invest in are more likely to go into default.

Another potential downside to these funds is lack of liquidity. You can buy into these funds at any time, but many of them can only be sold once a quarter (these are officially known as continuously offered closed-end funds), so you have to know when you're going to need your money. Nevertheless, many newer loan-participation funds, including the ones we suggest, can be redeemed daily. Unfortunately, there are still relatively few no-load loan participation funds with reasonable expenses. That's why we've included the Fidelity Floating Rate High Income fund (FFRHX) among our picks, despite its lack of a three-year return. This no-load fund sports an expense ratio of 0.9% compared with the category average of 1.1%.

Our advice on loan-participation funds is this: These funds are worth the risk unless there are clear signs that the economy is turning downward, or if you'll need the money within the next 12 months. No matter what, you'll have to keep an eye out, but the extra returns are worth it. Click here for a look at our picks.

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