Investors seeking equity-sensitive returns and higher income often turn to funds that invest in convertible securities. But this fund category encompasses a wide variety of styles and strategies; some funds allocate 80 percent or more of their assets convertibles, while others allocate much less. Here’s one of our favorite options.

Selectivity is the key for Jackie Benson, who succeeded Northern Income Equity’s (NOIEX) longtime manager Ted Southworth in 2007. Hewing to the fund’s established strategy, she only invests in convertible securities if they offer higher income and lower downside risk than a company’s common stock.

The fund’s allocation to convertible securities can vary widely. At present, the security class accounts for about 37 percent of the fund’s holdings, while common shares account for 59 percent of investable assets. Accordingly, Morningstar places the fund in its Moderate Allocation category, as opposed to the Convertible Securities group.

That leeway has led to varied performance over the years. In 2007 the fund underperformed the category by 2.5 percent, but outperformed in 2008 and finished 2009 in the middle of the pack–proof that Benson is settling in. Generally speaking, the fund lags in bull markets but tends to outperform when conditions deteriorate.

Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined level. This conversion threshold is set when the security is issued.

Although yields on convertible securities tend to fall between those of a bond and those of a common stock, convertibles compensate by allowing investors to profit if the company’s share price rises significantly. Convertible bonds have a maturity date, whereas convertible preferred stocks do not. However, both instruments are usually callable.

Convertibles offer an interesting and often lower risk way to participate in a stock’s upside potential. Convertible stocks that trade well below their conversion threshold perform similar to the underlying common stock; convertibles that trade near their conversion values behave more like bonds.

Like most asset managers, Northern Funds maintains a proprietary in-house database of the securities or asset class in which it specializes. Benson and her team screen a database of about 1,500 companies that have issued convertible securities, focusing on earnings growth and other fundamentals.

Sometimes the fund buys issues that have fallen out of favor with the markets but are fundamentally sound and offer above-average dividend yields. Thanks to a steady stream of cash, the fund can afford to hold until the markets rediscover the value of the issue in question.

But looking for issues that are down on their luck doesn’t mean the fund buys into busted convertibles, high-yielding issues that have little likelihood of conversion; Benson usually sticks to convertibles that trade within a reasonable range of their conversion threshold.

Of late, Benson has focused on high-quality issues that trade with limited volatility–a strategy shift that led the fund to underperform slightly last year. It’s not that Benson has eschewed higher-yielding issues entirely; she’s merely selective.

The fund and its peers face near-term challenges, as new issuance has tailed off significantly. Many companies are hesitant to test the market with new securities when their common shares trade at relatively low valuations and Treasury yields are at historic lows. In this environment it’s cheaper to issue common shares or borrow additional capital–many issuers have called in their convertible bonds already.

Assuming the US economic recovery remains on track, the fund should enjoy a tailwind from Benson’s bets on convertibles issued by energy, materials and industrial companies. She’s also making selective bets on health care–for example, common shares of Johnson & Johnson (NYSE: JNJ) and Glaxo-SmithKline (NYSE: GSK) and convertible shares issued by Amerigroup Corp (NYSE: AGP), which provides managed care services in the Mid-Atlantic and West.

The fund isn’t likely to generate substantial capital gains this year, but a yield of 2.1 percent provides an income cushion.