EDITOR'S NOTE: This article is from Kiplinger's Mutual Funds 2008 special issue. Order your copy today.
If you feel confused, even dazed, by the thousands of mutual funds available, you’re forgiven. But with the Kiplinger 25, we've screened this vast universe for you and picked the best stock and bond funds to help you meet your wealth-building goals.
Our rigorous selection process is part science, part art. We only consider funds with no sales load -- why start out in the hole? -- and we generally avoid funds with high ongoing expenses. Like sales loads, steep expenses are a serious drag to wealth building over time. We also pick funds with modest minimum initial investments, typically $2,500 or less, so most people can build a portfolio using just these funds (see page 30 for some recommended portfolios). And we shy away from unwieldy funds afflicted with asset bloat.
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We also closely examine the track records of portfolio managers—the longer, the better. Outstanding long-term performance is a given, but we also pay attention to how those results are achieved. Consistency is important, as is the link between returns and risk. Funds that have produced modest returns are perfectly acceptable if they've taken below-average risks. And one subpar year doesn’t disqualify a fund from consideration—no fund excels year after year. Managers who are personally invested in the funds they run get extra credit. We like skin in the game.
Returns in this story are to December 1, 2007. For more current results, see our fund tables.
Large-company stock funds
Tom Marsico has made a name for himself investing in large, fast-growing companies, first at Janus and later at his own shop, where he now manages Marsico Growth and Marsico Focus with aplomb. Marsico 21st Century borrows some of the best ideas from those funds, such as Goldman Sachs and Wells Fargo, and mixes in some stocks of midsize and small companies. Managed by Cory Gilchrist, 21st Century's 21% annualized return over the past five years trounced the gain of Standard & Poor's 500-stock index by an average of ten percentage points per year.
All the Marsico funds employ big-picture forecasting and company-by-company analysis. For example, Gilchrist says he was drawn to Heineken, the venerable Dutch beer brand that has a strong position in such emerging markets as Russia and Nigeria, where growing wealth means more money is available for premium brews. (Marsico 21st Century has 14% of assets in foreign stocks.) And in Amylin Pharmaceuticals, Gilchrist thinks he’s found a biotech winner with a “revolutionary” diabetes drug, Byetta, that may someday displace insulin.
Rob Bartolo took the helm of T. Rowe Price Growth Stock in October 2007, replacing Bob Smith, who had skillfully piloted this fund for more than a decade (Smith is now running T. Rowe Price International Stock). Like Smith, Bartolo looks for companies that can sustain annual growth of 15% over three to five years and that sell for a reasonable price. Surprisingly few companies have the stamina to maintain 15% growth for five years, he says, especially in a slower economy. The winners are generally companies that can sell more while raising prices.
Bartolo had co-managed T. Rowe’s media and telecommunications fund, so you can expect to see more of those tech names in Growth. He also says he's selling some Big Pharma names, such as Novartis, because of a less favorable political environment, but is adding health-care supply firms, such as Becton-Dickinson. Some of his first buys were beaten-down financial stocks, such as Moody's and McGraw-Hill, owner of Standard & Poor's. He intends to run a more concentrated portfolio, he says, trimming the number of stocks from 125 to about 100 and raising the weight of the top ten from 20% to 25%.
Vanguard Primecap Core is one of those growth-oriented funds that stays out of trouble even in frothy markets. That’s because the low-profile team of six portfolio managers at subadviser Primecap Management applies a value orientation to growth stocks and invests for the long haul. It’s a relatively new fund, but the five-year annualized return of its sister fund, Vanguard Primecap, is 16%.
The managers look for industry leaders with sustainable advantages derived, for example, from research-and-development spending, superior technology or unique products. For instance, Primecap Core holds Corning for its lead in liquid-crystal-display glass materials and Monsanto for its productivity-enhancing seed technologies.
When Chris Davis and Ken Feinberg buy a stock for Selected American Shares, they expect a long-term relationship. Selected holds shares for more than ten years, on average, a millennium by mutual fund standards. Davis and Feinberg search for durable, powerful franchises that sell at attractive prices, and they have a soft spot for companies run by managers who, as Davis puts it, "underpromise and overdeliver" to shareholders.
The Selected duo tries to identify businesses being propelled forward by long-term tailwinds. They are fond of American Express, the fund's largest holding, because more consumers are using credit cards as a method of payment at home and abroad, rather than relying on cash and checks. Davis and Feinberg are also buying global leaders, such as insurance giant AIG, because overseas markets are generally growing faster than the U.S. market. Their formula works: Over the past decade, Selected American has returned 14% annualized, beating the S&P 500 by three percentage points per year, on average.
Bill Nygren says he thinks in five-year terms when he considers stocks for Oakmark Select. He likes to shut out the daily noise on Wall Street and in the media and focus on long-term basics, such as the loyalty of a company's customers and its ability to generate cash and increase market share. "I think like a business owner, not like a trader," he says.
What excites Nygren now is that he's finding high-quality, large businesses with shares that sell at average prices. He figures these stocks will benefit from both rising earnings and higher price-earnings ratios. One such company is Western Union, the money-transfer business, which caters to migrant workers around the world. Among companies with strong international growth prospects, he holds Discovery and Yum! Brands, which operates KFC, Pizza Hut and Taco Bell restaurants. Select has struggled a bit over the past couple of years, but its long-term record is outstanding (ten-year annualized return: 12%), and Nygren is a disciplined investor.
Fund managers don't come much steadier than Brian Rogers, of T. Rowe Price Equity Income, who also serves as chairman of the Baltimore, Md., asset-management company. Rogers notes that Equity Income was meant to be a conservative stock fund for retirement accounts when it was launched in 1985, and it still serves that purpose admirably. Rogers has piloted Equity Income for its entire ride, returning 13% annualized.
Rogers likes stocks that sell at below-market P/Es and pay above-market dividends. Equity Income has a strong value bent, but these days, says Rogers, he's finding value in traditional growth stocks, such as drug maker Eli Lilly. Rogers also likes companies, such as General Electric and Johnson & Johnson, that steadily raise dividends.
Dave Williams, manager of Excelsior Value & Restructuring, says he's no slave to elaborate corporate spreadsheets. "We don't do much financial analysis," he says. Instead, he looks for industries under stress or undergoing consolidation. He likes shares of beaten-down homebuilders, such as Centex, that are selling near book value (assets minus liabilities). Williams also looks for industries and businesses that are profiting from long-term trends. He's a believer in strong global economic growth driven by surging developing nations, such as Brazil and China. That's one reason he likes United Technologies, which books most of its revenues abroad. His approach may sound simple, but his fund delivers the goods: a 12% annualized gain over the past decade.
Small- and midsize-company funds
It's not easy to find good small-company funds that are still open to new investors, but we've found one in Baron Small Cap. Steered by Cliff Greenberg since its inception in 1997, the fund has returned 13% annualized in the past ten years. That's six percentage points a year better than the benchmark Russell 2000 index over the decade.
Baron Funds has an outstanding record of making money in medium-size companies, and Greenberg is able to tap into the firm’s strong research team. He says he looks for “one-off ideas,” by which he means he studies individual company situations carefully rather than thinking in index or sector terms when he invests. He seeks to compound earnings over the long haul and holds his stocks for an average of three years.
Greenberg generally avoids technology and biotech stocks because it’s harder to project the future of these. Instead, he prefers consumer businesses, such as gaming, lodging and for-profit education, where he thinks he has a good feel for the future. For example, he recently added to his position in Emeritus, a leader in the assisted-living housing industry. He holds both Strayer Education and Capella Education, adult-education outfits.
Jim Barrow and Mark Giambrone relish investing in today's market. "As value managers, we're able to pick up former growth companies," says Barrow. As a result, the fund they run, Vanguard Selected Value, has a higher proportion of faster-growing midsize companies than usual. The fund's five-year annualized return: 16%
Barrow describes his search for attractive companies this way: "We're like Hansel and Gretel. We follow the crumbs through the woods." Demographic trends show an increase in both low-income residents, such as immigrants, and well-heeled older folks. So Barrow bought Advance Auto Parts, which caters to low-end consumers who need to squeeze more life out of their cars, and Royal Caribbean International, a cruise line with a big base of senior customers who have plenty of time and money on their hands.
What happens if you apply a Warren Buffett-style value-investing discipline to small growth companies? You get a roaring success. FBR Focus has generated an annualized gain of 14% over the past decade under Chuck Akre. He looks beyond price for businesses with high returns on capital, ample opportunity for reinvestment and managers who serve their shareholders' interests. "When you have those three factors, you get a compounding machine," says Akre, who works out of horse country in Middleburg, Va.
Akre seeks to compound money at 15% to 20% a year with low risk, and his success speaks for itself: a ten-year annualized return of 14%. So successful has he been at identifying "compounding machines" that many of the small companies in his highly concentrated portfolio have blossomed into much bigger concerns. Akre keeps them. "We don't have to cut our flowers to water our weeds," he says.
Julius Baer International has compiled a dazzling record, returning 17% annualized over the past decade. The fund is closed to new investors, but there's a fine alternative in Julius Baer International II, piloted by the same dynamic duo, Rudolph-Riad Younes and Richard Pell, who run the original.
Younes says International II holds essentially the same portfolio as the original fund, but without the small-company stocks. About a third of the fund is allocated to stable blue chips, such as Nestlé, the Swiss multinational food giant. Most of the rest is in stocks that Younes figures can double in three years and triple in five. In picking those stocks, Younes looks at long-term economic and industry trends. For instance, he's bullish on Eastern Europe because he believes those economies will blossom over the next two decades as the former eastern-bloc countries catch up with their cousins in Western Europe. He also believes that Indian banks are a screaming buy because their market values are tiny compared with the burgeoning Indian economy. "I can't see how you can lose money in Indian banks," he says.
Younes is also upbeat about the prospects for luxury-goods makers, which serve the rising nouveaux riches in emerging markets such as Russia, China and the Middle East. "The fastest way for the newly rich to show their wealth is through luxury products, such as jewelry and expensive watches," he says. So Younes has loaded up on bauble-maker Bulgari and the parent companies of Gucci, Louis Vuitton and Burberry.
David Herro is on a roll. The fund he manages, Oakmark International, has returned 14% annualized during his nearly 15-year reign. It turns out that Oakmark's value discipline (Herro says he looks for stocks selling for at least 30% below their true worth) works as well overseas as it does at home. "We're value people," he says. "You have to consider price."
These days, he's finding value in European drug stocks; Novartis and GlaxoSmithKline are two large holdings. He also loaded up on DaimlerChrysler shares, betting that the German automaker is in the early innings of a restructuring after unloading Chrysler.
The worst thing you could say about Dodge & Cox International Stock is that its recent returns (26% annualized over the past five years) are unlikely to continue. Other than that, it's hard to find fault with this gem. Its performance is excellent, and its risk and fees are relatively low. Dodge & Cox's team-management style obviously yields shrewd collective judgment.
Analysts and managers study purchase candidates intensively and subject the companies to a range of scenarios to assess what could go wrong. "If we lock this portfolio away for five years in a box, what's the likelihood that we would find it diminished in value?" asks Diana Strandberg, one of nine portfolio managers. "We think of ourselves as part-owners of the businesses."
Chris Alderson has run T. Rowe Price Emerging Markets Stock since its inception in 1995, so he knows a thing or two about riding a roller coaster. "Emerging markets are a volatile asset class," he says. London-based Alderson, who steers the fund with three co-managers based in London and Singapore, manages risk by holding a diversified portfolio of about 140 stocks and focusing on steady growers that are selling at reasonable prices.
He says most developing economies are in fine shape these days, with generally sound fiscal policies, reduced debt levels and strong currencies. Some of his favorite plays are Brazilian and Mexican banks and Indian-infrastructure companies. Over the past decade, this fund had an annualized 17% return.
A disciplined value fund, Fairholme plays a mean game of defense as well as offense. If they can't find bargains, managers Bruce Berkowitz, Larry Pitkowsky and Keith Trauner let cash build to 20% to 30% of assets, then use the money to pounce on seductive opportunities tossed up during market corrections. The trio conduct thorough "investigative reporting" on companies and their bosses before they invest. They'd better. Fairholme's top-ten holdings recently accounted for 68% of assets. Their methods work: Fairholme has returned 17% annualized since its inception in late 1999, compared with the S&P 500's 9% annualized return. It made good money even in the 2000-02 bear market.
Companies on Fairholme's roster are strong cash generators and have rock-solid balance sheets. But what Berkowitz and company really seek are outstanding managers who not only align their interests with those of their shareholders but also invest capital shrewdly. "We've put together a group of young Warren Buffetts," says Berkowitz. (Buffett's Berkshire Hathaway is a large holding.)
Berkowitz thinks he's found a Canadian Buffett in Murray Edwards, a billionaire who's tied up in three oil-and-gas holdings in the Fairholme fund. "Murray is a brilliant capital allocator," says Berkowitz. Fairholme has made a bundle in Edwards's Canadian Natural Resources, which bought oil assets cheaply and is a low-cost, rapidly expanding producer of petroleum. Berkowitz thinks the company can increase production 10% a year for 15 years and has enough oil-sands reserves to last 40 to 50 years.
With Legg Mason Opportunity Trust, you get Bill Miller without handcuffs. "The fund is as unconstrained as a mutual fund can be," says Miller, whose streak of beating the S&P 500 at Legg Mason Value for 15 straight years ended in 2006. "Unconstrained" means Miller can pretty much run the portfolio like a hedge fund. He can buy commodities and currencies along with stocks and sell short the shares of companies he thinks are overvalued.
So what does he like? His largest industry weighting is in steel stocks. Miller sees a long-term structural change in this basic industry because of global consolidation, which he believes will reduce cyclicality and improve cash flow. "This is no longer a boom-bust industry," he says. An independent thinker, he is also loading up on home-building stocks, such as Centex and Pulte, because many are trading at or below book value. Opportunity has outpaced the S&P 500 by an average of six percentage points a year over the past five years and has beaten Legg Mason Value by an average of five points a year.
John Montgomery says he never reads Wall Street research or visits companies and that he knows little about fundamental analysis. He leaves work in Houston each day without knowing whether the market went up or down. Yet the MIT-educated engineer is a highly successful fund manager, thanks to his elaborate, computer-driven models.
Montgomery closely guards the "intellectual property rights" of his secret recipe. But he says he employs 16 different models that focus on such variables as financial ratios and risk measurements. Bridgeway Aggressive Investors 2 invests in companies of all sizes, but Montgomery hints at the way he thinks the market -- and his fund -- is moving: "I think the pendulum is swinging back to large-cap growth, which will be the sweet spot of the market for five years." Aggressive Investors 2 has returned an annualized 21% since starting in 2002.
You can't accuse Ken Heebner of indecisiveness. The manager of CGM Focus reads the tea leaves and reconstructs his portfolio accordingly in a flash. But because Heebner has keen instincts and a fine sense of rhythm, his idiosyncratic method works. Focus has been on a tear since the beginning of the century, returning 25% annualized.
The past few years have been unforgiving to Ron Muhlenkamp. His Muhlenkamp fund fell 10% in 2007, lagging 15 points behind the S&P 500. Over the past three years, his fund was flat, lagging the index by an average of eight percentage points per year. Over ten years, Muhlenkamp sports a fine record—up an annualized 9%, an average of three points a year ahead of the S&P—but clearly he's stumbled badly in recent years. "I held housing [stocks] too long," Muhlenkamp explains ruefully.
He made money for shareholders during the housing boom by investing in homebuilders, but he failed to eject these holdings before the housing and housing-related credit-market collapse. Muhlenkamp, a keen economic observer, says his key error was failing to observe that mortgage originators were increasingly making loans to customers with shaky credit records even as interest rates were moving up in 2005–06.
He's shifting his portfolio away from financials and makers of long-lasting products aimed at U.S. consumers and moving toward capital-goods producers. "I want capital goods made in the U.S. and shipped to the rest of the world," he says, noting that a falling dollar and stronger economic growth overseas is shifting purchasing power to foreign buyers and away from American consumers. As with many fund managers, Muhlenkamp is rejiggering his portfolio to benefit from the crumbling U.S. dollar.
The beauty of Merger fund is that it doesn't move in lock step with the stock market. In fact, you can almost view Merger as a high-yielding bond fund, but without the interest-rate risk. The fund has returned 6% annualized since its inception in early 1989 and has had only one down year.
The three managers, Fred Green, Roy Behren and Mike Shannon, buy shares of companies involved in buyouts after the deals are announced. Let's say Company A makes an offer to acquire Company B for $10 a share. Target Company B's stock will likely sell at a discount to the transaction price, maybe at $9.50 a share, because there's some risk that the deal will fall through. Merger's managers size up the deal and, based on their analysis, determine whether it makes sense to invest in B's shares in hopes of capturing the final 50 cents of appreciation (more than 95% of deals are consummated). At the moment, there's plenty of merger activity in both the U.S. and Europe, a plus for the fund because it gives the managers plenty of choices.
Kathleen Gaffney, co-manager of Loomis Sayles Bond, says she and partner Dan Fuss think of themselves as value investors in the fixed-income world. "We're sellers into strength, buyers into weakness," she says. The duo make the most of the fund's flexible mandate, opportunistically scouring the world for the best bond deals.
For instance, they're bullish on the Singaporean dollar, so they bought General Electric bonds denominated in that currency. That way, their fund can capture both the interest from the bonds and currency appreciation, assuming their expectations pan out.
Fuss and Gaffney are keen on natural-resources producers, so they’re keen on Canada, which, unlike the U.S., is paying down its debt and running trade surpluses. The pair stuffed the fund with Canadian debt and bought bonds of other big commodity exporters, such as South Africa and New Zealand.
Loomis Sayles demonstrates what happens when you give some talented and imaginative bond investors a little freedom to roam. Over the past decade, the fund returned 9% a year, beating the stock market by an average of more than three percentage points per year. It yields 6%.
If you invest in Harbor Bond, you've hired the highly respected Bill Gross and his team at Pimco (the fund closely resembles Pimco Total Return). Gross predicted that the housing market would lead to a weaker economy and that the Federal Reserve would slash short-term interest rates aggressively in the second half of 2007. So the Pimco team packed Harbor with Treasury and government-agency bonds that mature in two to five years.
Gross and team think the limp dollar will continue to decline against the euro, the yen and the currencies of many emerging markets, so Harbor is carrying an above-average weighting in foreign bonds. The fund yields 5.6%.
The folks at Dodge & Cox have made a name for themselves running excellent stock funds. But they're no slouches in the fixed-income arena, as shown by the consistent performance of Dodge & Cox Income. The medium-maturity bond fund features the San Francisco fund manager's hallmarks: low fees, strong research and risk management.
Dana Emery, one of the nine members of the team that runs Income, says her group sees the potential for higher long-term interest rates. As a result, the portfolio's average duration -- a measure of the degree to which the price of a bond or bond fund is likely to react to changes in interest rates -- is well below that of the fund's benchmark. The managers have also reduced holdings of corporate bonds because they feel they're not being paid enough for the risk.
Fidelity is another fund family that doesn't get enough credit for its fine fixed-income offerings. The nice thing about Fidelity Floating Rate High Income is that it can perform well even amid rising interest rates, an environment that's unfriendly to most bond funds. That's because the bank loans held in the portfolio are repriced every three months or so, whether rates rise or fall. The fund has been highly consistent and conservatively run. It yields 6.9%.
If the tax man is driving you into municipal bonds, you could do much worse than to invest in Fidelity Intermediate Muni Income. Manager Mark Sommer is avoiding high-yield munis, which he thinks are overvalued. "We're biased toward higher-quality, essential services, such as sewage, water and education," he says. He has also added bonds in states such as California, where he thinks a windfall from capital gains and executive stock options is creating extra demand for munis from well-heeled investors. The fund yields a tax-free 3.6%, which is equivalent to 5.0% for taxpayers in the 28% bracket and 5.5% for those in the top, 35% bracket.
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