The Best Funds for Nervous Investors

Every once in a while you notice a small drawback about investing, such as, say, the occasional horrific plunge that makes you wonder if you'll ever be able to retire.

The timing of this year's slide was particularly troublesome, as taxpayers are usually flush with tax refunds and bonuses to deploy. Yet there are funds for the skittish that allow you to get your feet wet but won't leave you high and dry if stocks spring back soon. And no, we're not talking about pricey funds that use hedge fund tactics.

Turn to hybrid investments

A convertible bond, as the name implies, is debt that can be converted into the company's stock. The bonds become more valuable as share prices rise; if the stock languishes or falls, you still get paid interest, though less than what conventional bonds offer. Over the past 20 years convertible funds averaged 6.9% a year, vs. 7.3% for the S&P 500 with dividends reinvested.

Convertibles are issued by companies of all sizes, but some are smaller firms that can be at risk in a weak economy, warns David King, portfolio manager at Columbia Threadneedle Investments. Among the top holdings of SPDR Barclays Convertible Securities , though, are securities issued by blue-chip names like Wells Fargo and Intel. The ETF is up 6.6% annually over the past three years. That's half the S&P 500's returns but three times the gains for bonds.

Use options as a cushion

Covered call funds sound exotic, but they're not. These funds sell call options—the right for others to buy your stock at a set price—on their holdings. The contracts bring in income that can cushion losses in a downturn. If prices rise enough for the option to be exercised, though, your gains will be limited.

"Options are a better risk-management tool than bonds," since they always move in the opposite direction of stocks, which isn't guaranteed with fixed income, says Randy Swan, manager of the Swan Defined Risk fund. Over the past year PowerShares S&P 500 BuyWrite Portfolio has been up 1.89% while the S&P 500 is off 0.5%. In 2008 the ETF lost nearly 29%—but that was eight points less than the broad market.

Take a balanced approach

The simplest option is the one you're most familiar with: balanced funds, which are typically invested about 60% stocks and 40% bonds. Fixed-income yields are still low, but even at these levels bonds offer you protection. In January, when the S&P 500 fell 5%, Vanguard Balanced Index lost 2.8%.

If stocks come roaring back, though, these funds won't shine. But if you're nearing retirement or just tired of being terrified, they'll help you stay in the game.

Correction: The original version of this story misstated the name of the Swan Defined Risk fund.

Columnist John Waggoner is the author of three books on Wall Street and investing.