8 Best Fund Types to Use in a Recession

8 Best Fund Types to Use in a Recession

When the economic outlook is unclear, such as in the case of a recession, investors tend to take a more conservative approach to their investment portfolio. There is fear that stock markets may have sold off, so a lot of people are looking to change what they own in their investment accounts. In a recession, the goals of identifying investments that will withstand the downturn, provide stability and, hopefully, some return, is especially pertinent. This blog takes a look at eight fund types that tend to work well under the stress of a recession and why they work. We will also take a look at how to include these kinds of funds in a diversified portfolio.

1. Federal Bond Funds

Summary: Federal bond funds are invested in US Treasury bonds, considered one of the safest investments in the world. They are backed by the full faith and credit of the US government, which means that the risk of default is virtually zero. In a recession, these funds become especially popular with more conservative investors seeking to protect their capital.

Why They Work in a Recession: As the bedrock of the US financial system, Treasury bonds come with a guarantee that no other investments can match. In the event of a recession, when stock markets become volatile and shaky, Treasury bonds provide a sort of financial sanctuary, because even in a recession their guaranteed return works out just fine. Moreover, because the US government can tax and print money at will, Treasury bonds represent a trustworthy instrument of receiving income returns, even when the economy is performing at a lesser level.

How to Use Them: You can use federal bond funds as insurance for your portfolio, especially if you’re nearing retirement or would like to reduce your exposure to risk during periods of economic turmoil. They won’t provide you with the highest returns, but they’ll guarantee a safer ride in a well-diversified portfolio.

2. Municipal Bond Funds

Municipal bond funds. These funds invest in bonds issued by local and state governments. Because they are supported by local taxing authority, the bonds offer a somewhat higher level of safety than corporate bonds. Although municipal bonds are not as secure as federal bonds, they are nonetheless low-risk investments.

Why They Work in a Recession: Many of them are issued by state and local governments, so they’re less vulnerable to economic slowdowns than many other bonds, as the revenues that ultimately fund the bonds come from taxes or specific projects. In a recession, they can offer a much-needed stable income stream, plus you won’t have to pay federal income taxes on their interest payments (and sometimes not state and local taxes either).

How to Use Them: Municipal bond funds are great for investors who want an intermediate level of safety with an intermediate return. They’re an especially good choice for those in the upper tax brackets, since they’re tax-exempt. Using these in your portfolio can make a recession a little more cushioned, while still netting you some return.

3. Taxable Corporate Bond Funds

The Taxable Corporate Bond Funds are open-end mutual funds that invest in bonds issued by corporations rather than governments. The advantage of corporate bonds over government securities is that they usually yield more while carrying less risk. The risk of these bonds depends on the financial stability of the corporation issuing them.

Why They Work in a Recession: Yes, corporate bonds are more risky than government bonds, but they are generally less volatile than stocks. That’s especially true of high-quality corporate bonds, particularly from large, well-established companies. Because large, stable companies are best-positioned to weather an economic downturn, high-quality corporate bonds are likely to keep paying their interest, even if the economy falters.

How to Use Them: Investors should include taxable corporate bond funds in a balanced fixed-income investment strategy. Choose funds that focus on high-quality, investment-grade bonds for the least risk, with superior returns to government bonds and more stability than equities.

4. Money Market Funds

These mutual funds, unlike other securities, invest in only ultra-short securities like Treasury bills, certificates of deposit (CDs) and commercial paper. They are the most ‘risk-free’ and ‘zero-risk’ funds you can open.

The reason for that, as mentioned earlier, is the fact that the funds cannot simply sell securities they own to cover their investors’ redemptions. Instead, they must sell other securities in their portfolio at a loss to obtain the money. This process, known as “breaking the buck,” occurs when money market funds sell securities at a discount to cover redemptions, which can be fatal for the fund.

Why They Work in a Recession: Money market funds are extremely liquid, with no risk of loss of principal Money market funds dominate short-term savings for individuals during a recession. If the economy starts imploding, people want a higher level of safety for their cash.

The low returns of money market funds are more than compensated by their extreme liquidity—there’s no risk of your cash being tied up during a market rout and very little risk of losing your principal. In times of trouble, you can “park” your cash in these funds as a temporary holding place, allowing you to withdraw it at will until the storm passes and better opportunities emerge.

Use Them: To Create Liquidity If you have been laying low with your money, you may need to get liquid soon. Big purchases can come up, and money market funds are a good way to create liquidity for yourself.

Use Them: To Create an Emergency Fund If you haven’t yet built a cushion for yourself, money market funds are a safe way to create one. They won’t make you rich, but they will give you peace of mind to weather the economic storm.

Don’t Use Them: As a Long-Term Growth Vehicle These funds aren’t going to make you rich, they’re meant to offer peace of mind for the bumpy ride ahead.

5. Dividend Funds

What it does: Dividend funds focus on stocks that pay regular dividends to their shareholders. For that reason, these funds are known as income-oriented, although they may also appreciate in value. The income stream comes from the dividends, which the investment manager typically hopes will increase over time. Dividend funds tend to hold well-known companies that have a track record of paying dividends. Because most companies prefer to pay increasing dividends, a fund of such companies will tend to be less volatile than a growth-oriented equity fund.

Why They Work in a Recession: In a recession, companies that pay consistent dividends tend to be viewed as lower-risk investments in the eyes of the market. They are typically strong, well-managed companies that continue to generate so much cash flow that they can afford to pay you a dividend during hard times. The combination of income and lower risk makes dividend funds attractive when the market is down.

How to Use Them: Dividend funds can be an attractive part of a diversified portfolio, especially for income-seeking investors. You can reinvest dividends to enhance long-term returns. During an economic downturn, dividends provide a cash flow source that helps mitigate losses in more volatile investments.

6. Utilities Mutual Funds

Funds: Utilities Mutual Fund Its purpose: These funds typically invest in the stocks of large companies who supply essential services to people, like electricity, gas and water. Revenues of these companies tend to be more stable as people will always require electricity and gas, regardless of the economic climate.

Why They Work in a Recession: Utilities are considered “defensive stocks” because their demand remains stable, even during a recession. People still need electricity, water and other utilities, so utilities companies are less likely to see large drops in revenues. As a result, utilities mutual funds are less volatile than their counterparts and can provide a steady income through dividends.

How to Use Them: If you’re concerned about knuckling under to the recession, consider utilities mutual funds for the conservative portion of your portfolio. With their steady returns, these funds can help smooth out the volatility of a more aggressive portfolio. Utilities funds are perfect for cautious investors or those nearing retirement.

7. Large-Cap Funds

Large-cap funds: These are funds that invest in large companies – those with market capitalisations of more than $10 billion. They tend to be mature companies with a proven track record. Companies in this category are more likely to have survived economic downturns.

Why They Work in a Recession: By their nature, large-cap stocks tend to be less susceptible to economic shocks than small- or mid-cap stocks. They tend to have diverse revenue streams, international exposure and better access to capital – their business models better equip them to survive, and perhaps even thrive, during a recession. Large-cap funds instil an element of safety that’s not present in smaller companies.

How to Use Them: Plump for plump. Large-cap funds can dampen portfolio volatility. They’re ideal for the investor who wants to stick with equities but would prefer a softer landing. You can use large-cap funds as a core holding in a diversified portfolio, rather than as a satellite holding, which is a fund or security that makes up only a small portion of your portfolio.

8. Hedge Funds and Foul Weather Funds

Summary: Hedge funds are alternative investments that use different strategies to produce investment returns, regardless of market conditions. A foul weather fund is a type of hedge fund that specifically focuses on performing well during a market downturn.

And why they work in a recession: Hedge funds use techniques such as short selling, derivatives and leverage to protect against or benefit from market declines. Foul weather funds are more likely to pursue strategies that are likely to succeed when primary markets go haywire. Hedge funds are much riskier than most other investments (though they had a good year in 2008) but are the only widespread vehicles that could benefit from the financial crisis.

Whenm: Because of their complexity and risk, hedge funds and foul weather funds should make up only a small percentage of your portfolio. They’re really only appropriate for sophisticated investors or those who have accumulated a substantial balance. They offer the potential for diversification and protection against a major market downturn.

The Bottom Line

A recession calls for prudence and a measured approach to investing. A rush to safety might be tempting but, with a diversified portfolio including some exposure to the kinds of funds described here, you can endure the economic storms without sacrificing long-term prosperity. If you choose your investments in line with your appetite for risk and your financial goals, you can safeguard your portfolio in a downturn – and set yourself up for prosperity thereafter.

No matter what kind of investment you’re doing, your mantra should always be: forget about market timing. Nobody has a clue. You just need to build a basket that will withstand any kind of fire. If you have federal bond funds, municipal bond funds, taxable corporate bond funds, money market funds, dividend funds, utilities mutual funds, large-cap funds, and a couple of selective hedge or foul weather funds, you’ll be in a great place to survive a recession and come out on top.