In the financial turmoil of the past decade, mutual fund investing has gotten decidedly more complicated. After all, over the course of just 10 years, investors have looked on as two bear markets ravished the economy, as a pair of bull markets jolted stocks back to life, and as the Internet and housing bubbles inflated to their breaking points and then burst.
For investors, the search for the perfect mutual fund has always been something of a holy grail quest. But in the midst of the past decade's abrupt market cycles, investors have approached their fund-hunting efforts with newfound intensity. With that in mind, U.S. News has created a unique rankings system that is designed for long-term investors looking for broad access to information about funds. In the process, U.S. News has assigned scores to upwards of 4,500 distinct mutual funds.
[Use the U.S. News Mutual Fund Score and the rankings of trusted fund analysts to find the best mutual funds for you.]
Overall, the scores—which are based on data from Morningstar, Zacks, Lipper, TheStreet.com, and Standard & Poor's—take into account short- and long-term performance, risk, expenses, and future prospects.
[See our methodology.]
So what do the best mutual funds look like? To explore this, U.S. News has analyzed its top-ranked fund from each of the following 11 Morningstar categories: large growth, large value, large blend ("blend" funds have both growth and value characteristics), foreign large blend, diversified emerging markets, health, short-term bond, intermediate-term bond, intermediate government bond, world bond, and moderate allocation. Overall, the 11 category-topping funds have quite a bit in common. Here are some traits that they share:
High-conviction portfolios. Pat English, a comanager of FMI Large Cap (FMIHX), which is the top-scoring large-blend fund in the U.S. News rankings, likes to say that only his team's best ideas will make it into the fund's portfolio. And he means it: FMI Large Cap generally owns just 25 to 30 stocks at a time. "We're not big believers in sheer numbers of names," says English.
Neither is Don Yacktman, a comanager of the Yacktman Fund (YACKX), which tops the large-value category. At the end of 2009, the fund owned fewer than 50 securities. "Beyond a certain point," Yacktman says, "the more diversification, the more likely one will get mediocre returns."
Meanwhile, for its part, Fidelity Select Medical Equipment and Systems (FSMEX), the best-ranked health fund, finished 2009 with just under 60 stock holdings.
Broadly speaking, running a heavily concentrated fund is a risky proposition. If even one bet goes sour, the fund is certain to feel the blow. At the same time, though, concentrated portfolios allow managers to invest only in companies they know intimately. "Concentrated portfolios can be more volatile but aren't necessarily so," says Adam Bold, the founder of the Mutual Fund Store, an investment management firm with more than 65 U.S. locations.
Another measure of portfolio conviction is a fund's turnover ratio, which quantifies how frequently management trades. Funds with low ratios have buy-and-hold mentalities and tend to have high degrees of confidence in their picks. Overall, the 11 funds have turnover ratios that are an average of 78.7 percent lower than their category averages.
Low costs. It's one of the perennial mutual fund debates: Should investors focus primarily on costs or on returns? In a vindication of cost-based fund picking, the 11 mutual funds examined by U.S. News have expense ratios (a measure of annual fees) that are, on average, 0.32 percent less than their category averages.
"Costs play a big role in fund returns. You tend not to see it if you look too close up. In other words, if you look at a single year, that advantage of, say, 50 basis points or whatever isn't that big, especially in years like '08 or '09 when you've got huge negative or positive returns," says Russel Kinnel, Morningstar's director of mutual fund research. "But over time, it adds up to quite a significant difference."
Overall, this phenomenon is somewhat circular in nature. "Good performance leads to more assets, and more assets generally drive down expenses," says Kinnel.
Still, costs are one of the most contentious issues in the fund industry. "There are some things in life that are worth paying more for. There's a reason that a Mercedes-Benz costs more than a Kia," says Bold. "To me, it doesn't matter how much you pay the mutual fund company. What counts is how much they pay you."
Ultimately, though, this tension between costs and returns may be more imagined than it is real: The funds that top the U.S. News rankings provide superior returns, and they do so at low costs.
Talented and consistent management. Six of the 11 category leaders have at least one manager who has been on board since the fund's inception. Overall, this continuity of management seems to boost a fund's ability to consistently apply strategies that will pay off in the long term.
English, who has been a comanager of FMI Large Cap since it launched in 2001, says low manager turnover helps funds develop coherent cultures. "The main thing is the culture," he says. "You need continuity because it's hard to spread that culture if you have a lot of change."
For his part, Bold says that picking a good management team is one of the most important decisions an investor can make. "The name of the fund doesn't matter," he says. "What counts are the people who are every day making the buy, sell, and hold decisions."
Among the top-performing funds in the U.S. News rankings, the biggest question mark in the management arena pertains to TCW Total Return (TGLMX), the best-scoring fund in the intermediate-term bond category.
Late last year, TCW fired Jeffrey Gundlach, who had served as the company's chief investment officer and was a celebrated comanager of the flagship Total Return fund. In the aftermath of the firing, Philip Barach, the other Total Return manager, also left TCW, as did dozens of other employees.
[For more on Gundlach's ouster, see The Decade's 10 Worst Fund Disasters.]
With the fund's two managers out the door, TCW quickly turned control of Total Return over to Tad Rivelle of Metropolitan West Asset Management. Rivelle brings significant experience to the job, but it remains to be seen how the shake-up will affect the fund's long-term performance.
Another management theme is that all 11 category leaders have active managers. "Actively managed funds are going to have a wider dispersal of performance," says Kinnel. "Those are the ones that are always going to be at the top and bottom of the rankings." At its most basic level, this cuts to the core of the active-passive debate. A good index fund, Kinnel says, will consistently earn investors market performance, but that's as far as it will go—its mandate isn't to beat the market.
Downside protection. After two bear markets in the course of a single decade, investors have learned the hard way that high-quality funds not only will earn more than the competition during strong markets but will also lose less during downturns.
The 11 top performers' returns beat their category averages by an average of 7.4 percent in 2008, primarily thanks to some well-timed defensive positions. Some residual indicators of these funds' defensive stakes still linger, largely in their cash holdings. As recently as the end of last month, for example, Sextant International (SSIFX), the top-ranked foreign large blend fund, had roughly 40 percent of its portfolio stashed away in cash.
Many of the other top-ranked funds also have large cash stakes. "When we feel that we've filled up on the really good ideas … we'd just as soon sit on some cash. If the opportunities are there, we'll buy things. It's just a matter of if they aren't attractive enough, we'd rather just sit on some [cash]," says Yacktman, whose fund had upwards of 11 percent of its portfolio in cash at the end of last year.
The reason large cash positions helped during the downturn is that they shielded funds from losses in the stock and bond markets. "A lot of the funds with good cash stakes naturally lost less in 2008," says Kinnel. "I don't think there's anything inherently good or bad about running with a lot of cash. I think it's just what works for the manager."
Another way the 11 funds protect their investors during bear markets is through careful stock picking. "We spend a great deal of time protecting the downside by making sure we don't overpay for anything on the front end," says English.
Meanwhile, some of the top-ranked funds hold up decently during recessions because of the very nature of their mandates. Health funds, for example, are commonly considered to be among the most defensive of investments, and they tend to outperform their competitors during weak markets. In 2008, Fidelity Select Medical Equipment & Systems lost 23.4 percent. By comparison, the S&P 500 was down by 38.5 percent that year.