During the 1990s bull market, many financial advisors embraced style-pure funds, so-called because the funds adhere to a single style, such as small value or mid-cap growth. Most advisors — and institutions, for that matter — shunned flexible funds that drifted around the style-box, emphasizing small-caps one month and large-cap stocks another month.

As stocks soared, advocates of style-pure strategies gained more confidence in their favorite managers. Funds focused on large growth — such as Janus Twenty and Harbor Capital Appreciation — delivered huge returns. Meanwhile, Fidelity Magellan, a fund that was famous for roaming widely, appeared to be an also-ran.

Besides delivering high returns, style-pure funds gained popularity because they fit easily into asset allocation plans. If a plan calls for putting 10 percent of assets in large value stocks, the advisor can select a pure manager and be confident that the allocation will remain steady. In contrast, flexible funds can shift their holdings, throwing allocations out of kilter.

Style-pure managers gained favor with institutional investors partly because of their use in asset allocation. Pure funds began marketing themselves as “institutional quality” investments. The label attracted advisors who reckoned that the pure funds must be better choices to mitigate asset allocation headaches, yes, but also stood a better chance at delivering higher returns.

All-Weather Heretics

But in this decade, style-pure funds seem less compelling. At a time when most market sectors are falling, pure funds typically remain fully invested in their style boxes, a strategy that can result in big losses. Flexible funds can maneuver, emphasizing healthy industries and avoiding trouble spots. The brightest star of the current bear market may be Kenneth Heebner, portfolio manager of CGM Focus, which has returned 35.4 percent annually during the past five years. Ignoring style boxes, Heebner achieved his record by shifting dramatically, loading up on energy stocks and shorting financials.

The success of CGM and other top performers suggests that flexible funds can play an important role in portfolios. By holding cash or selling short, flexible managers can cushion downturns, and research suggests that flexible funds can hold their own once a bear market ends. In a recent study, Morningstar compared the returns of style-pure and flexible funds. The conclusion: The two kinds of funds finished in a dead heat during the past decade. “Advisors shouldn't feel guilty about holding flexible funds,” says John Rekenthaler, vice president of research for Morningstar.

Rekenthaler says that advisors can construct entire portfolios of flexible funds. But many advisors may feel more comfortable holding only a flexible fund or two in portfolios that include mostly pure choices. “I have a general preference for style-pure funds,” says John Sterba, president of Investment Management Advisors, a N.Y.-registered investment advisor that clears trades through Schwab Institutional. “Around the edges, I like to have flexible managers who can add some diversification and maybe boost returns.”

Some of the most intriguing choices are flexible funds that hold broad mixes, including growth and value as well as stocks of all sizes. These eclectic portfolios can excel in a variety of market conditions. A top performer is Hodges Fund. Hodges had most of its assets in small stocks during 2002, a year when large caps lagged. Figuring that blue chips will outperform in today's difficult markets, the fund now has most of it holdings in mid-caps and large stocks.

Portfolio manager Craig Hodges once worked as a stockbroker. In that job, he learned how to screen through the entire investment universe in search of the best ideas. “If you just own big stocks, then you are guaranteed to go through long stretches when your style is out of favor,” says Hodges.

Another fund that holds stocks of all sizes is Thornburg Value. Portfolio manager William Fries divides his portfolio into three categories: value stocks, emerging companies with rapidly growing earnings and blue chips with steady growth. Lately, the portfolio has emphasized steady growers such as Microsoft. “We like companies with established brand franchises and high returns on equity,” says Fries.

While his competitors may stick to benchmarks, Fries ranges widely, buying unusual stocks and often emphasizing particular sectors. Recently the fund held Gazprom, a Russian gas giant. The portfolio had 10 percent of its assets in telecom, three times the weighting that the sector has in the S&P 500.

Among the most successful funds lately have been asset allocation specialists with broad mandates. These funds can shift to cash or foreign bonds while underweighting stocks. Consider PIMCO All Asset, which has the freedom to invest in asset classes around the world. During the 12 months ending in June, PIMCO stayed in the black, a noteworthy accomplishment in a period when the S&P 500 lost 13.3 percent.

PIMCO portfolio manager Rob Arnott, of Research Affiliates, the sub-advisor to the fund, has protected shareholders by virtually avoiding stocks and investing in fixed income. The fund has big positions in Treasury Inflation-Protected Securities. These rise along with the consumer price index. Arnott is particularly bullish on emerging market bonds. “While the U.S. is running a big fiscal deficit, many of the emerging countries are running surpluses,” says Arnott. “One could argue that some of the emerging market debt is more creditworthy than U.S. Treasuries are.”

During the past year, BlackRock Global Allocation has outdone the S&P 500 by about 20 percentage points. The fund stayed afloat by holding a big cash stake and avoiding financial stocks. “We have little confidence in the asset quality of banks and brokers,” says Mike Trudel, managing director of BlackRock.

The fund recently achieved nice gains by shorting retailers and other consumer companies. At a time when consumers are burdened by huge debt, they are not likely to go on shopping sprees, says Trudel.

A cautious stance has helped FPA Crescent, which surpassed the S&P 500 by 15 percentage points in the past year. Worried about the outlook for financial stocks, portfolio manager Steve Romick has about 35 percent of assets in cash. “When we saw the credit issues, we decided that it was the better part of valor to sit on the sidelines,” says Romick.

FPA Crescent owns an eclectic mix of holdings, including stocks, bonds and convertibles. Romick buys whatever seems to be undervalued; lately he has been grabbing junk bonds, securities that many other investors shun. By taking contrarian positions, Romick has recorded positive returns for the last eight consecutive years.

PLAYING THE FIELD

Flexible funds that avoid big losses.

Fund Ticker Category Three-year
Return
Five-year
Return
% Category Rank
Five-Year Return
Maximum
Front-End Load
Blackrock Global Allocation MDLOX World Allocation 13.0% 14.4% 18% 5.25%
FPA Crescent FPACX Moderate Allocation 9.5 11.2 2 0
Hodges HOPMX Mid-Cap Growth 11.8 18.9 1 0
PIMCO All Asset PASAX Moderate Allocation 4.8 7.0 43 3.75
Thornburg Value TVAFX Large Blend 6.5 8.1 34 4.50
Source: Morningstar. Returns through 6/30/08.