The Kip 25: Our Favorite Mutual Funds, 2013

After a year when nearly everything worked, why make changes? As the saying goes, "If it ain't broke, don’t fix it." Over the past 12 months, most markets posted gains. Standard & Poor’s 500-stock index returned 16.2%, and developed foreign markets climbed 12.8%. A broad index of high-quality U.S. bonds earned a modest 2.7% over the 12-month period, but high-yield corporate bonds and convertible bonds produced double-digit gains.

See Also: The Kiplinger 25 at a Glance

As for the Kiplinger 25, the list of our favorite no-load mutual funds, all but one (a commodity fund) gained ground. In one way, that made our task in compiling this year’s list easier than usual—we didn’t have to consider removing any funds for outright awfulness. (For more on how our funds fared in 2012, see A Wonderful Year for the Kip 25). All returns below are through March 8.

But this year, we decided to take an extra-close look at the bond funds in the Kip 25. Bond investing isn’t easy these days. Yields on supposedly low-risk Treasury bonds remain in the gutter, and the additional interest you collect from lesser-quality bonds is low by historical standards. When interest rates begin to rise in earnest, bonds will lose value and so will funds that invest in them (the yield on the ten-year Treasury bond has already jumped from a low of 1.4% last July to 2.1%).

Because the Federal Reserve is committed to keeping rates low until the economy is on sounder footing, we don’t expect that a bear market is imminent. But in the interest of safety in a category that is normally the province of cautious investors, we wanted to include more bond funds that are well positioned to withstand rising interest rates.

In particular, we chose two new bond funds from the closely related multisector and unconstrained categories. And we avoided funds with hefty stakes in long-term government bonds, which are especially sensitive to rising rates, and focused instead on funds with lower average durations, a measure of interest-rate sensitivity. We also added a new emerging-markets stock fund. (See more on how we choose all the funds in the Kip 25.)

A new stock fund

The managers of some emerging-markets stock funds start by assessing the big picture. At Harding Loevner Emerging Markets, the focus is on finding outstanding companies.

The process starts with screens. Managers G. Rusty Johnson, Craig Shaw and Richard Schmidt use filters to identify growing, high-quality companies—firms that boast high and sustainable profit margins and return on equity (a measure of profitability), carry little debt, and exhibit consistent growth, as measured by rising sales, profits or dividends. Then they dig deep, talking to company officials, competitors and industry analysts who cover the stock. The managers make their own sales and profit forecasts, which they use to estimate what they think a company is worth.

Finally, all of the portfolio managers and analysts at Harding Loevner, a Bridgewater, N.J., firm that focuses on foreign stocks, discuss the companies under consideration. "People beyond the emerging-markets team are key to the discussion," says Johnson. "Collective teamwork provides insight and minimizes errors."