Don’t give up on active management. The Kiplinger 25 identifies tomorrow’s rising stars. The Heads of State By Nellie S. Huang, Senior Associate Editor From Kiplinger's Personal Finance, May 2015 Thinking about ditching an actively managed stock fund for an index fund? You have tons of company. Over the past year, investors have yanked $110 billion out of actively managed U.S. stock funds and put much of it into index funds. But you can still win the investing Grand Prix with humans at the controls, and the funds in the Kiplinger 25 give you a great shot at doing just that.Turn the Kip 25 into a Portfolio for You: Short-, Medium-, Long-Term Still, there’s no sugarcoating the fact that actively managed stock funds have been enduring a miserable run. In 2014, only 10% of active stock funds that focus on big U.S. firms beat Standard & Poor’s 500-stock index, which is geared toward large-capitalization stocks. The performance of the Kip 25, our favorite actively managed no-load funds, was pretty much in line with the rest of the world. Of our five mostly big-cap U.S. stock funds, none beat the S&P 500, although Davenport Equity Opportunities, which invests in companies of all sizes, did prevail. But what’s done is done, and we urge those of you who are thinking about abandoning active management to reconsider. The stock market dynamics that so strongly favored big cap indexes last year are unlikely to persist. Active funds suffered last year because, essentially, large-cap stocks beat everything else: mid-cap stocks, small-cap stocks and foreign stocks. And even within large caps, shares of the behemoths generally did best. Advertisement Stock market returns are likely to be far more democratic over the next few years. That’s because, as the Federal Reserve slowly abandons its ultra-easy monetary policy, investors are likely to focus less on the stock market’s attractiveness relative to other asset classes and more on the strengths and weaknesses of individual companies. Says Kristina Hooper, the U.S. investment strategist for Allianz Global Investors: “This is when active managers shine.” And this is where the Kip 25 comes in. Despite the past year’s sluggish results, our funds boast outstanding long-term records. Does that mean our picks will continue to excel? No one knows for sure. And, truth be told, we wouldn’t begrudge you owning a mix of index funds and actively managed funds. That is a defensible strategy. But over time—Kiplinger’s has been writing about mutual funds since the 1950s, and we introduced the Kip 25 in 2004—we have learned that certain characteristics lead to success. First, low operating costs are crucial for overcoming the biggest advantage of index funds: their usually microscopic expense ratios. We also favor funds run by managers with strong long-term track records who demonstrate a clearly defined strategy for picking securities. We prefer funds with below-average volatility for their category, and we keep a close eye on a fund’s size because a gargantuan asset base makes managing a fund difficult. Advertisement We’re not afraid to say good-bye to a fund. The easiest call: We remove a fund if it closes to new investors. But we may also eject a fund when its manager changes, when it grows too big or when it lags its peers over an extended period. This year, we add three new funds. Below, a closer look at the new members of the Kip 25. Artisan International As manager of Artisan International (symbol ARTIX) since its 1995 launch, Mark Yockey has seen a lot of action: the Asian contagion of the late 1990s, the more recent European financial crisis, China’s rise as an economic juggernaut, the stagnation of Japan’s once-mighty economy and stock market, and the rise and fall of many emerging markets. Through it all, his stock-picking process has remained the same. He invests in “killer companies” that dominate their industries, stand to benefit from long-term global trends and throw off a lot of cash. “We’re looking for companies that will continue to grow for the next five to 10 years,” says Yockey. And they have to be attractively priced relative to their growth rate. Take Baidu, the Chinese search engine firm and the fund’s biggest holding. Yockey says Baidu’s earnings will grow by 34% next year, but the stock’s price-earnings ratio is just 26 (based on estimated earnings). Of course, not every holding is growing at that pace. In fact, says Yockey, “we’re not focused on high growth or low growth. We’re focused on price relative to growth.” Yockey, 58, and comanagers Andrew Euretig and Charles-Henri Hamker, who joined in 2012, can invest in any size company, but they focus on large outfits in developed markets. The fund at last report had 40% of its assets in European stocks in developed countries, which, Yockey says, look “really cheap.” But it can invest up to 35% of its assets in emerging-markets stocks, and recently the fund had 16% of its money in those kinds of stocks—mostly Chinese Internet and technology companies, including Baidu, Alibaba and Tencent. When the managers buy, they do so with the intent to hold for at least three to five years. One holding, Swiss food giant Nestlé, has been in the fund for 14 years. Advertisement Artisan’s long-term record is solid. Since its launch, it has gained an annualized 10.1%, nearly twice the return of the MSCI EAFE index, which tracks stocks of large companies in developed foreign markets (all returns are through March 6). Annual expenses are 1.17%, compared with 1.26% for the typical large-company foreign fund. Yockey says the fund’s $18.5 billion in assets is a “drop in the ocean compared to the $40 trillion in market value available in global markets.” T. Rowe Price Diversified Small-Cap Growth When smart fund managers see a good opportunity, they seize it. So it’s reassuring that in the late 1990s, Sudhir Nanda, then a professor of finance, realized that his academic expertise in stock market research might be better rewarded if he were a money manager. He left teaching and joined the quantitative analysis team at T. Rowe Price in 2000. Nanda, 55, now runs the firm’s group of number crunchers, as well as Diversified Small-Cap Growth (PRDSX). Since he took the reins in October 2006, the fund has returned 12.0% annualized, well ahead of the 7.9% annual return of the Russell 2000, a measure of small-company stocks. Diversified Small-Cap Growth is the only quant fund in the Kip 25. Nanda relies mostly on numbers—price-earnings ratios, price-to-sales ratios and return on equity (a measure of profitability), to name just a few—to ferret out small, high-quality firms that trade at discounted prices. But he will examine fundamental business factors when necessary. For instance, in 2008, as many banks teetered on the abyss, he sought help from Price’s banking analysts to identify potential failure candidates. These and other sector specialists also occasionally play a role in refining Nanda’s screens—informing him, for instance, of which measures might matter most for a specific industry. In the end, Nanda wants the same thing as many other fund managers who dig into the nitty-gritty: companies with growing profits run by executives who reinvest those earnings wisely, and stocks that trade at bargain prices. That focus helped the fund hold up better than other small-company funds during the downturns of 2008 and 2011. Diversified Small-Cap Growth lost 36.3% in 2008, and it climbed 1.5% in 2011. Compare that with the average fund that focuses on small growing companies, which tumbled 41.6% in 2008 and lost 3.6% in 2011. “If I can avoid heavy losses in the bad markets, I should do better over the long term,” says Nanda. Advertisement The fund is well-diversified, with about 300 stocks. And Nanda really does buy and hold. The portfolio’s 17% turnover rate suggests that he holds a stock about six years, on average. That compares with an average turnover ratio of 85% for the typical small-company growth fund. Assets total a reasonable $1 billion, and annual expenses clock in at 0.82% per year, far below the average small-company fund fee of 1.22% per year. T. Rowe Price Value Manager Mark Finn loves controversy. The hullabaloo can involve a company, an industry or even the entire economy. If it brings down a stock’s price, Finn is interested, especially if he’s convinced that the company is poised to turn around and, hence, that it has been unfairly tarnished. Granted, this kind of contrarian strategy can be treacherous. In late 2014, Finn bought shares of Genworth Financial, an insurance company that reported bigger-than-expected losses for the year. As a result, the stock has dropped 9% so far in 2015. “I’m not afraid to buy as stocks fall,” says Finn, 52. He’s not afraid to sell when the market is moving against him, either. Last June, T. Rowe Price Value (TRVLX) had 11% of its assets in energy stocks, just as oil prices were about to embark on a treacherous decline of more than 50%. Finn trimmed his position to 4% by the end of 2014 by eliminating several energy holdings, including Royal Dutch Shell, the Netherlands-based integrated giant. Finn’s gutsy calls have worked out well. From his ascension as Value’s manager in January 2010, the fund has returned 15.6% annualized, edging the S&P 500’s annualized return of 15.1% and beating the average large-company stock fund. And although Finn didn’t beat the S&P 500 in 2014, he came darn close: His 13.4% gain lagged the index by 0.3 percentage point. The fund’s a bargain, too. Its 0.82% expense ratio is far below the average of 1.25% for diversified U.S. stock funds. Value’s asset base of $21 billion is by no means tiny, but Finn believes it is manageable. Turn the Kip 25 into a Portfolio for You: Short-, Medium-, Long-Term Why we kicked out three funds If we had a working crystal ball, the job of shepherding the Kiplinger 25 would be a lot easier. But we don’t. So we think long and hard before we remove a fund; in truth, we agonize over every change. Sluggish performance isn’t the only reason for removing a fund from the Kip 25. Factors such as manager changes, a shift in strategy and too much money (known as asset bloat) come into play, too. Complicating matters is that if we want to remove a fund, we must also have a worthy replacement to fill its slot. Take T. Rowe Price Small-Cap Value (symbol PRSVX), for instance. We’re thinking about replacing it: The fund has $9 billion in assets, an awful lot for a small-company fund. (Trading large quantities of stocks can adversely affect their prices, and that goes double for small-company stocks.) Moreover, the fund’s longtime manager, Preston Athey, retired last June after 23 years at the helm. But we can’t find a solid substitute—one that charges no load, has below-average fees and a reasonable initial minimum, truly focuses on small undervalued companies, and is run by a manager with a superior long-term record. Some searches were fruitful, however. We were able to find a replacement for Baron Small Cap (BSCFX), which we are sidelining because of a growing asset base. With $5 billion under management, it’s getting harder for Small Cap to focus on, well, small caps. According to Morningstar, 54% of the fund’s assets are in midsize companies. We replaced Baron with T. Rowe Price Diversified Small-Cap Growth (PRDSX), a smaller, less expensive fund. We’re removing Cambiar International Equity (CAMIX) after one year in the Kip 25, even though the fund beat the key foreign-stock benchmark, the MSCI EAFE index, by breaking even for the year. But when the going gets rough overseas, we feel more comfortable trusting our foreign-stock money with a manager who’s seen it all. So we replace Cambiar with Artisan International (ARTIX), run by 20-year veteran Mark Yockey. In with one Artisan fund, out with another. Since we added Artisan Value (ARTLX) in May 2012, the fund has trailed the S&P 500 and the typical large-company fund. We’ve had our eye on T. Rowe Price Value (TRVLX) for a while. It has delivered better results than Artisan over the past five years, and it charges less (0.82% versus 0.98%).