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Now is the time to step lively, be aware

I made the thinly-veiled suggestion last week that investors should reduce their holdings of stocks. It is only right that I offer some suggestions as to what to do instead, and I will. But first, an important point of information is required.

We all learned during the tech boom and bust that, when an analyst makes a recommendation, an investor deserves to know just what that analyst is doing with his or her own money.

As a holder of the Chartered Financial Analyst designation, I am further duty-bound to disclose what role any investments that I discuss here play in my own portfolio or in my business.

My personal portfolio is invested in only two things right now: A short position in the S&P 500 and cash. My clients’ portfolios have an average reduction in equity exposure of about 40 percent. This means that if an investor has a long-term risk objective consistent with a 60 percent stocks exposure, we might have only 36 percent of the portfolio in stocks.

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The natural question is, where is the rest of the money? While cash yields have been on the rise recently, the yields on cash instruments remain quite low.

My first alternative is short-term bond funds. When interest rates rise sharply, these funds will experience a small reduction in share price. At first, investors might be prone to panic and sell out. Don’t. Be patient. Remember that money you put into short bonds used to be in stocks, and so is intended to be left alone for a while. Short-maturity bond funds have a return pattern like a “J.” The share price initially suffers a small amount, but then the total return begins to rise above the previous baseline as the bonds in the fund roll over into the newer, higher-interest bonds.

The next category that I like is bank-loan mutual funds. I use the Fidelity Floating Rate High Income Fund because I can buy it with no load and low fees. This fund invests largely in commercial loans originated by banks. The interest rates are variable and rise when the Fed moves rates up.

They are high-quality loans and pay a healthy spread above Treasury bills. The only downside to these loans is that they can be somewhat illiquid, and many bank-loan mutual funds will impose a penalty on you if you sell your shares before 90 days has passed. As with the short-term bond funds, this should not be a problem since we are talking about long-term money anyway.

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These two investments are attractive alternatives to money-market funds, but we should not expect high returns. As you begin to look for higher returns, two things might tempt you: high yield bonds and real estate investment trusts. I have about as much confidence in these two asset classes as I do in stocks. High yield bonds will, at first glance, appear to pay much higher spreads than regular bonds. However, that spread is at its lowest point in history.

The little bit of extra yield does not come close to compensating you for the additional default risk of junk bonds. Real estate investment trusts are similarly at the extremes of an historic value range.While the dividends are tempting, they remain low by historic standards, and the share price can only go down from here as the business cycle rolls on.

I am reluctant to recommend some of the more exotic strategies, such as hedge funds, because so many hedge funds are taking exactly the risks I am telling you to avoid. I will stop there and just implore you to be extremely careful. You should only consider low-risk, no-leverage funds. I have client money in hedge funds, and I seek out only conservative and experienced managers.

An attractive alternative to hedge funds that I have bought for most client accounts is the PIMCO All Asset Fund. This fund makes statistical investments in an underlying selection of 12 asset-specific funds. Its return objective is to earn a positive spread over inflation under all market conditions.

This is the same objective as many hedge funds, and the PIMCO fund is available to any investor from discount brokers and other firms. I consider this a good alternative to stocks until such time as stocks are cheap again. I would be comfortable placing as much as a third of my money in just this one fund.

We have grown so used to having stocks as the core holdings in our portfolios that many of us have forgotten how to find alternatives. They are out there.

Write to Rick Ashburn at rick@richardashburn.com or 7777 Fay Ave., Suite 230, La Jolla, 92037.