INVESTORS' NERVES HAVE

certainly been tested over the past three weeks. Since the stock market finished above 14,000 on July 19 there have been eleven trading days of wild, 100-plus point swings. Indeed, the market rallied for three straight trading sessions this week gaining 153 points on Wednesday alone only to shed a majority of those gains in a 387-point sell off on Thursday. Even the Federal Reserve's decision to keep interest rates unchanged couldn't stabilize the market's jitters.

The volatile environment hasn't been kind to mutual funds. According to Lipper, the average diversified equity fund had returned 12% when the market hit its high. Since then, that tally has been cut by more than half to 4.25% as every major fund category has taken it on the chin. Small-company stock funds have been particularly hard-hit, especially value offerings that are now in the red year-to-date after being up as much as 9%. Industry watchers are divided over what's in store for the rest of 2007.

One category of funds, though, managed to stem some of the bleeding and should do so in the future if the market continues to slide. This week, we turned our focus to balanced funds, a category of offerings that combine large equity stakes with smaller bond components, making them a good mix for conservative investors. Balanced funds number in the thousands, but only 13 made our cut after we finished narrowing down the possible candidates based on fees and performance.

The concept behind these funds is simple. The equity portion, usually around 60% of assets, gives shareholders a way to participate in any rally without the risk of an all-stock portfolio. Balanced offerings will typically lag those all-stock funds, but when the market reverses course, the bonds help cushion the blow by producing returns that beat their competitors. That makes for a win-win situation for investors who don't fancy themselves arm chair stock pickers.

"The bonds typically aren't correlated to the stock market so [the fund's] decline won't be as great as a 100% equity portfolio," says Ray Benton, founder of Benton & Company in Denver.

For the most part, that is what has happened so far this year. According to Lipper, this category was trailing the typical diversified equity fund by roughly four percentage points through mid-July. Since July 19, however, these funds have lost less than the broad market. A sampling of five balanced funds that we profiled in February has performed in a similar way. Those funds Buffalo Balanced, Fidelity Balanced, James Balanced: Golden Rainbow, Mairs and Power Balanced and T. Rowe Price Balanced were lagging by 1.5 percentage points through mid July. This group, too, lost less in the downturn and now has year-to-date gains that are slightly ahead of the S&P 500. (However, two of our previous picks the James Balanced Golden Rainbow and Mairs and Power Balanced did not perform well enough to stay in our most current screen.) "When the market softens on the equity side you get a zing from the fixed income," says Todd Rustman, co-founder of GR Capital Asset Management in Newport Beach, Calif.

That puts investors at an interesting juncture. One of the primary reasons to invest in a balanced fund is to protect your nest egg with little worry. It also means, though, that at times you are taking a bearish bet that the market won't be humming along. Indeed, when we have done this screen in the past we inevitably hear from bullish investors who say they can do better in funds like Fairholme or Dodge & Cox Stock (If you can still get in it). Those naysayers are right you can get fatter returns elsewhere. But for investors who are trying to protect their investments an especially important detail the closer you are to retirement and for those that just don't have the stomach for the roller coaster rides that we're currently enduring, balanced funds can offer some peace of mind. "We have clients who don't mind feeling the high of the highs and the low of the lows," says Chris Campbell, president of Bryn Mawr Trust Brokerage Services Group. "But we also have clients who don't want to take on that much risk." We think these funds are excellent core holdings for both types of investors.

One of the best funds in this category is the $26 billion Fidelity Balanced. This fund's equity portion about 62% of the total portfolio spans the size spectrum, allowing for healthy positions in small and midcap stocks. That has definitely helped performance over the last several years, but as those smaller fry stocks cool off, it may be difficult for co-manager Lawrence Rakers to keep posting above-average numbers. Indeed, the fund is in the top 3% of its peer group over the trailing 3-, 5- and 10-year periods. Top holdings include fixed income positions in Fannie Mae bonds and Treasurys as well as stocks like AT&T and General Electric.

The Criteria
The balanced funds that made our list were open to new money, required a minimum of under $5,000 and charged an expense ratio of less than 1.5%. They also had performance track records over the trailing 3- and 5-year time periods that put them in the top 40% of their peer groups and they had to have year-to-date returns that exceeded that of the S&P 500. Although Lipper includes target retirement date funds in this category, we stripped them out since they get their own screen during the course of the year.