Our favorite stock funds soared and most beat their benchmarks. And all but one of our bond fund picks outpaced the bond market. By Nellie S. Huang, Senior Associate Editor January 3, 2014 Many of the world’s stock markets soared in 2013, so it’s no surprise that the Kiplinger 25, the list of our favorite mutual funds, enjoyed a bang-up year. But most of our funds did even better than their benchmarks, including those that invest in markets that didn’t soar. See Also: The Kiplinger 25 at a Glance U.S. Stock Funds The group’s 12 U.S. stock funds gained an average of 36.0%, beating Standard & Poor’s 500-stock index by 3.6 percentage points. Highlights included three funds that focus on large-capitalization stocks: Dodge & Cox Stock (DODGX), which climbed 40.6% in 2013; Mairs & Power Growth (MPGFX), which earned 35.6%; and Fidelity Contrafund (FCNTX), which gained 34.2%. All handily outpaced the S&P 500’s 32.4% return last year. But one of our large-company funds lagged. Artisan Value (ARTLX), which we added to the Kip 25 in 2012, trailed the index by 6.6 points. Its 25.8% return ranked behind 91% of its peers in the large-company value category. “It’s not odd for our group to lag in a big up-market,” says George Sertl, one of the fund’s managers (along with Scott Satterwhite, Jim Kieffer and Daniel Kane). “We’re anti-momentum investors, and we’re in a momentum environment.” Indeed. The four managers are contrarian investors, looking in pockets of the market that others are shunning. And they buy with a four-year time horizon. “It takes patience,” says Sertl. The fund’s cash holdings—about 10% of assets at last report—hurt performance, and two of its 34 holdings were real drags: Annaly Capital Management (down 18.3%) and Newmont Mining (down 47.8%), part of the awful gold sector. Advertisement It was an excellent year for active management in the midcap arena. The typical midsize-company fund gained an average of 34.7%, topping the S&P MidCap 400 index by 1.2 percentage points. Our picks shone. Wells Fargo Advantage Discover (STDIX) and Vanguard Selected Value (VASVX) each returned a bit more than 42%, which ranks them among the top 8% of all midsize-company funds. Akre Focus (AKREX) beat the peer group, too, with a 38.9% return. Only Fidelity Low-Priced Stock (FLPSX), with a return of 34.3%, failed to beat its peer group, albeit by a whisker—just 0.4 percentage point. As for our small-cap funds, it’s complicated. Don’t misunderstand--they did well. But their performance puts in stark relief the matter of absolute returns versus relative returns. Baron Small Cap (BSCFX), Homestead Small Company Stock (HSCSX) and T. Rowe Price Small-Cap Value (PRSVX) posted healthy gains of 37.8%, 36.6% and 32.7%, respectively. Yet all trailed the small-company Russell 2000 index, which climbed 38.8%. Indeed, active managers who focus on small companies on average trailed their benchmark in 2013. The typical small-company fund gained 38.2%, a bit shy of the Russell 2000’s advance. “Given the run that small caps have had, I’m happy to turn in a performance that’s close to the index,” says Peter Morris, who runs the Homestead fund with Mark Ashton and Stuart Teach. The fund got a boost from several huge winners. Cracker Barrel Old Country Store, a top-ten holding, climbed 75.2% in 2013. And the shares of shipbuilder Huntington Ingalls Industries nearly doubled. But Homestead’s assets have more than tripled, to $800 million, since we added it to the Kip 25. Morris says size hasn’t gotten in the way so far. But he and his co-managers have had discussions about how much more in assets they can handle. And, says Morris, “we’ve turned down large institutional blocks of money this year.” Apparently, investors tend to chase performance whether they’re pros or amateurs. Advertisement But Homestead’s assets look like chump change in comparison with those of Baron Small Cap, which holds close to $6 billion. Manager Cliff Greenberg says size hasn’t been an issue, yet. Foreign Stock Funds Our foreign-stock funds generally excelled, too, with all but one beating their benchmarks. Dodge & Cox International (DODFX) gained 26.3%, beating the 23.3% return of the MSCI EAFE index, which tracks stocks of large foreign companies in developed markets. The fund benefited from bets on European financials and a South African Internet firm called Naspers (up 102% in 2013). Matthews Asian Growth & Income (MACSX) returned 4.8% in 2013, which pales in comparison to most of the other stock funds on our list. But it outpaced its peer group—funds that invest in Asia—as well as its benchmark. Manager Robert Horrocks told us in 2013, when we added Asian Growth & Income to the Kip 25, that the fund’s focus on a mix of common stocks, convertible bonds and preferred stocks would smooth the ride for investors. He was right about that. Over the past three years, Asian Growth & Income has been 25% less bumpy than its peers. The fund has a 3.5% dividend yield. Advertisement And despite the flat (some might say horrible) year in emerging-markets stocks, Harding Loevner Emerging Markets (HLEMX) beat 81% of its peers by squeezing out a 4.2% return. The fund got a boost from generous stakes in two Chinese Internet firms: Tencent (up 97% in 2013) and Baidu (up 77%). Rusty Johnson, Richard Schmidt and Craig Shaw have done well lately with their holdings in China and Taiwan, as well as in less-established “frontier” markets, such as Panama, Nigeria and Qatar. “Our weight in China moved up,” says Johnson. The fund’s exposure to greater China, which includes Hong Kong-listed Chinese companies, grew from about 13% of assets in March to 20% at last report. The mix includes gambling companies (Sands China), technology firms (Baidu), and industrials (China Merchants Holdings). Relative to its benchmark, our biggest laggard among foreign funds was Harbor International (HIINX), which returned 16.4%. It was hindered in part by a below-average stake in Japanese stocks, which rallied strongly in 2013. Fixed-Income Funds When all is said and done, 2013 will likely mark the end of a 30-year bull market in bonds. Once the Federal Reserve indicated in early May that it would begin phasing out its mammoth bond-buying program, debt yields began a steady climb. The benchmark ten-year Treasury bond, which closed with a yield of 1.63% on May 2, finished 2013 with a yield of 3.03%. And because bond prices tend to move in the opposite direction of interest rates, the value of many fixed-income securities fell over the remainder of the year. The Barclays U.S. Aggregate Bond index lost 2.0%, its first annual decline since 1999. On average, the six bond funds in the Kip 25 beat the index by 2.2 percentage points. The best performer was Osterweis Strategic Income (OSTIX), a go-anywhere fund that at last report had 76% of its assets in short-term high-yield bonds. It crushed the index by 8.6 percentage points. “You have to stick with what you think are the best opportunities in the marketplace, and currently that’s short-dated, high-yield debt,” says Carl Kaufman, who runs the fund with Simon Lee and Bradley Kane. Strategic Income has been heavy on high-yield bonds, with a smattering of convertibles bonds, for the past five years or so. But over the past year, the trio trimmed a lot of the fund’s holdings in convertibles, which are part bond and part stock and would be vulnerable to a decline in the stock market. “I would love to own more, but we’re not seeing a lot of opportunity with stocks at all-time highs and yields at all-time lows,” says Kaufman. Advertisement Interestingly, Morningstar changed the fund’s category this year from multisector bond to high-yield bond, based on its holdings in the fund. (It is the second such change in seven years&mdash:in 2006, Morningstar switched the fund’s category from convertibles to multisector bond.) “Strategically,” says Kaufman, “I don’t think like a high-yield fund.” His advice: Don’t get bogged down about which category this fund fits in because it doesn’t fit neatly in any. It is a go-anywhere fund. Like Osterweis Strategic Income, Metropolitan West Unconstrained (MWCRX), run by Stephen Kane, Laird Landmann and Tad Rivelle, has the leeway to buy any kind of bond. In 2013, the fund did its job, staying well ahead of the broad bond market. It returned 2.9%, 4.9 percentage points ahead of Barclays US Aggregate Bond index. It was a mixed bag for the rest of our bond funds. How you assess their results depends on whether you focus on absolute returns or relative returns. Some funds posted minuscule gains or even lost money, but on a relative basis, they were standouts. DoubleLine Total Return Bond (DLTNX), for instance, was essentially flat for the year (down 0.2%), but that was better than 84% of its intermediate-term bond fund peers and outdid the Aggregate index by 1.8 percentage points. The story was roughly the same with our other bond funds. Though they hit rough patches&mdash:and posted negative returns&mdash:they handily beat their benchmarks and respective peer groups. For example, Fidelity New Markets Income (FNMIX), an emerging-markets debt fund, lost 6.4% in 2013, but that was better than 68% of its peers. And Fidelity Intermediate Municipal Income (FLTMX) lost 1.5%, but that was in the top quarter of results for all intermediate-term national muni bond funds. Finally, Harbor Bond (HABDX), an intermediate-term bond fund and a clone of Pimco Total Return, the nation’s biggest bond fund, had a so-so year. Harbor surrendered 1.5%, outpacing by a smidgen the Aggregate index and the 1.4% drop of the average taxable medium-maturity bond fund. But what you don’t see in the one-year return is the tumultuous year that manager Bill Gross and his compadres had at Pimco.