How Much Income, Growth? Don’t Lose Your Balance

Growth and income funds. Equity income funds. Balanced funds. They all sound the same, all using stocks and income from bonds and stock dividends to grow.

There are differences, and they matter in a long bull market, in which funds with a larger percentage of stocks do better than those reliant on more income.

But that reverses in bear markets, in which the income not only moderates declines but also helps the funds recover more quickly. Deciding which one is for you depends on your desired balance between a bull-market potential gain and a bear-market cushion.

Basically, the differences among the growth and income funds, equity income funds and balanced funds are in the proportion of income to equity.

* Balanced funds, which have the lowest return of the group in bull markets--74.2% over the last five years--usually get about 40% of their return from bonds and dividends.

* Equity income funds, which may hold bonds but also seek high yields from dividends, had a five-year return of 98.3%.

* Growth and income funds, which usually seek some dividend income but rely mainly on stock growth, returned 101.5%.

Standard & Poor’s 500 index funds, which are considered growth and income funds, returned 110% over the same period, in part because they usually have much lower expenses than managed funds.

It is not as if growth and income funds are undiscovered. If they are coupled with S&P; index funds, the class has about $430 billion under management, which puts them ahead of basic growth funds, which have $396 billion and which they outperformed in the period by 7 percentage points. And because they are considered relatively conservative compared with growth and aggressive growth funds, they are the largest single holding in most 401(k) accounts.

But equity income and balanced funds seem to be less well-known. Or understood.

“They all start at about the same place, but it is the degree of income that changes things. And most equity income funds have a value approach to investing,” said John Markese, president of the American Assn. of Individual Investors.

That means they focus on buying stocks that are trading at a discount to their “fair value,” rather than having the earnings-growth orientation of growth and income funds.

“There are distinctions between the two [growth and income and equity income],” said Brian Rogers, who manages T. Rowe Price’s equity income fund, “but sometimes those differences are splitting hairs. There are equity income funds that are a little growth, and some growth and income funds that are managed like value funds. You really have to see how these are managed.”

That’s because some fund families have a variety of balanced, equity income and growth and income funds, all of which take a different approach to investing, even though they may be called the same thing.

“There is more than one way to skin a cat,” said Vanguard group principal Brian Mattes. That company’s fund list includes six different growth and income funds, some of which rely on growth, others on value.

The investment approaches vary, even in value-oriented funds, which look for companies that are out of favor with the market, are overlooked or are in a sector like retailing, which hasn’t done well generally but has some companies that can do better, said Tom Reilly, managing director of the value equity group of Putnam Investments.

Reilly said he looks for dividend yields equal to or higher than the yield on the S&P; 500. The S&P; yields--calculated by dividing dividends by the share price--have fallen to less than 2%, mainly because prices have risen so much that a dividend that is steady in dollar terms becomes a smaller and smaller percentage of the share price.

Reilly’s most conservative fund, Balanced Retirement, has more than 50% of its assets in bonds all the time. The George Putnam Fund, also a balanced fund, usually has 30% to 40% of its money in bonds. But the equity income fund drops bond holdings to 10% to 20%, and the growth and income fund keeps only up to 10% in bonds. The ranges allow some flexibility to deal with market conditions.

“We are looking for growth, but with only about 80% of the volatility of the market,” Reilly said. “We control risk in the fund by varying the amount of exposure to fixed income.

“Bear in mind,” he said, that “it was much easier to recover from the crash of 1987 or the invasion of Kuwait because of the bonds in the portfolios.”

The income matters most in down markets, where it acts as an outrigger, stabilizing the funds’ performance. The more steady income, the more stable the return even as markets fall.

A fund whose shares have dropped 10% but that has a bond income of 6% can, depending on the ratio of stock to cash, recover much faster than a fund that has dropped the same amount but only has 2% income.

As stock values fall, Reilly noted, the proportion of bonds to stock will rise, so the mix has to be adjusted to keep proper balance. In bull markets, he said, the opposite kind of adjustment is needed.

“The important thing is to know what the fund manager is doing and is supposed to do,” Reilly said. “Get the prospectus before you buy, and check the Morningstar ratings to get an idea of how the portfolio is operating.”

If you are worried about a downturn but don’t want to miss much if the market keeps rising, you might want to consider an equity-income or balanced fund, depending on your risk tolerance.

“The equity-income funds are more defensive” than growth and income funds, Price’s Rogers said. “But there are investors who still want a reasonable return for every unit of risk.”