Investors, tired of weak returns and rising volatility in U.S. stocks, are turning to cash and fixed-income investments, including safer municipal bonds and Treasury inflation-protected securities.

Benchmark U.S. stock indexes have been weak since mid-May on a host of concerns: the length of the Fed's interest rate raising campaign; high oil prices; fighting in the Middle East; and signs that corporate profit growth could top out.

As a result, domestic stock funds suffered net redemptions for a third consecutive month in July, according to data tracked by Thomas McManus, chief investment strategist at Banc of America Securities in New York. Money market funds have become a major beneficiary of gyrating stocks, as investors poured almost $100 billion into them over the last three months.

It is likely that some of the increase comes from reduced equity exposure in individual accounts, McManus said.

Over the last three years, small-cap and mid-cap stocks have posted double-digit percentage returns, but many prominent investors, including Warren Buffett and bond manager Bill Gross, expect much more modest stock market returns in the years ahead, perhaps in the 5 percent to 8 percent range.

In comparison, the yields on money market funds have climbed to about 5 percent, drawing appeal from investors looking to diversify into safer securities.

Dan Genter, president of RNC Genter Capital Management in Los Angeles, said: You are seeing people say to themselves, 'If I am going to see this kind of volatility without high returns, I might as well be in the bond markets and not worry.'

STOCK ALLOCATIONS REMAIN UNDER BENCHMARK

Investors aren't writing off stocks completely, but they aren't ready to overweight them either.

A Reuters poll of 45 leading investment firms in the United States, Japan, continental Europe and Britain showed an average of 59.7 percent of portfolios were in equities at the end of July. That's below a benchmark weighting for stocks of 60 percent for the second month in a row. For more see .

Holdings of bonds, meanwhile, rose to an average 33.3 per cent from 33 per cent at the end of June, the highest level since May 2005. Cash holdings dropped to 4.4 percent from 5.0 percent.

After stocks' heady gains over the last three years, investors are certainly thinking of at least taking some chips off the table, said Kimon Daifotis, chief fixed-income investment officer for Charles Schwab Investment Management in San Francisco.

Despite their recent allure, though, bonds haven't fared all that well this year. The Lehman Aggregate bond index , the leading barometer of all types of bonds, has posted a measly 0.62 percent gain, as the Federal Reserve has steadily pushed up interest rates.

Genter says he's not surprised by the shift into fixed-income funds. He's been seeing a significant increase in demand for municipal bonds, as new and old high-net worth clients have demanded more diversification amid the turbulence in stock markets.

While municipal bonds pose much lower default risk than corporate bonds, the attraction to munis, of course, is that their interest generally is exempt from federal income taxes. If they are issued in the investor's home state, they're usually exempt from state and local income levies, too.

Investors have been buying in the 10-year maturity range, where high-quality tax-exempt municipal bonds yield between 4.10 percent and 4.20 percent, or the equivalent of about 6.50 percent on a taxable bond for an investor in the 35 percent federal tax bracket. That's about 1.50 percentage points more than the benchmark 10-year Treasury note , which was yielding just under 5.0 percent on Tuesday.

Schwab's Daifotis said he has seen a pick-up in flows in the Schwab Inflation Protected Fund (SWRIX.O: Quote, Profile, Research), which invests in Treasury Inflation-Protected Securities, or TIPS.

The reason is that TIPS' breakeven inflation rate, the spread between yields on nominal and inflation-linked yields, has fallen from a high of 2.74 percentage points at the beginning of May to around 2.58 percentage points

As a result, many TIPS buyers have re-entered the market at these levels, said Daifotis. He said many economists think inflation will accelerate faster than the Fed would like, which would also cause TIPS to outperform.

As with a traditional bond, the semi-annual coupon rate on a TIPS issue is fixed. TIPS' principal is adjusted annually to reflect the erosion of its value from inflation; thus the bigger the rise in the consumer-price index, the bigger the increase in TIPS' principal.

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