How We Pick the Kiplinger 25

There's nothing like recommending a bunch of funds with lousy records to stir up curiosity -- not to mention skepticism -- among our readers. This year's listing of the Kiplinger 25 (see The 25 Best Mutual Funds) generated more comments than usual. That's hardly surprising, given that all but one of our picks had lost money over the previous year.

Our harshest critic was Thomas Straka, a professor in the department of forestry and natural resources at Clemson University, in South Carolina. Wrote Straka: "It took a lot of guts to suggest the best 25 mutual funds, especially with no explanation of how you replaced the team that made the choices last year."

The good professor obviously doesn't believe in pulling his punches. But as a member of that team, I, for one, am not ready to walk the plank. By now, most of you have read about the singularity of the bear market (which, we hope, is over). The 55% decline in Standard & Poor's 500-stock index made this the worst rout since the Great Depression. Moreover, there was no place to hide-every stock-market style and sector faltered. To make matters worse, bonds also gagged. Just about the only things that made money during the downturn were bonds and cash.

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And that leads to the basic philosophy that underpins the Kiplinger 25: We recommend funds for the long term. We do not practice market timing or suggest buying what's hottest at the moment. So it's hard to conceive of a circumstance that would have prompted us to include bear-market funds, one of the few things that worked the past year.

And because we believe that the asset-allocation decision is best left to individual investors, rather than to fund managers, we recommend pure stock and bond funds, as opposed to balanced funds. Balanced funds, which own stocks and bonds, hardly distinguished themselves during the bear market, but they generally performed better than most pure stock funds. The one exception, added to our list in the January 2009 issue of Kiplinger's Personal Finance, is FPA Crescent, a go-anywhere fund that not only can own stocks and bonds but also can sell short stocks.

Our long-term focus also explains why some funds stay on our list even after they suffer an off year. We don't advocate using mutual funds for short-term trades. In fact, we typically replace only about one-fifth of the 25 each year.

The two picks that created the most consternation were Dodge & Cox Stock (symbol DODGX) and Loomis Sayles Bond (LSBRX). One reader asked why we had chosen Dodge & Cox in light of its poor performance last year, and noted that Morningstar gave the fund just three stars for overall performance and two stars for the past three years.

We can dispose of the Morningstar matter quickly: We don't care one iota about the star ratings. And apparently, neither does Morningstar. Among 192 Morningstar "analyst picks" in early May, 62 had three-star ratings, 15 were rated two stars and two had just one star. Eleven had no star ratings at all.

Analyzing performance is trickier. We study a manager's total record and try to avoid being unduly influenced by short-term results, be they good or bad. Dodge & Cox Stock's 43% loss in 2008 undermined the fund's long-term record. But from 1990 through 2007 the fund beat other large-company value funds 14 times out of 18 years. Over that period, it gained 14% annualized, beating the market by an average of three percentage points per year. The fund's superb long-term record and low expenses, plus the assessment of my colleague Andrew Tanzer, who traveled to San Francisco to meet the management firm's key players (see What Went Wrong at Dodge & Cox), led us to keep Stock in the Kiplinger 25.

Bond-market blues. It's a similar story with Loomis Sayles Bond: An aggressive fund with a fine long-term record sees that record wrecked by a single lousy year. Plus, how much blame can you assign the managers when the bond market simply went haywire for much of 2008?

Fortunately, 2009 is already shaping up as a better year for our picks, both on an absolute and a relative basis. This gives me hope that we'll receive fewer brickbats and more attaboys when we present the 2010 version of the Kiplinger 25 less than a year from now.