The Right Mix of Mutual Funds for You

In our January issue, I wrote that my daughter, Claire, had asked me where she and her husband, Zach, could get a higher rate on their savings. Unfortunately, I had to tell them that in this market, earning 1% or so in the bank is about the best that you can do (see Best of the Online Banks). But a longtime reader, Herbert Alleman of Silver Spring, Md., offered a refreshingly positive spin: "If one uses coupons and other incentives to buy needed products, the real savings is the money in your pocket that you don’t have to spend," he writes. For example, he figures he can save as much as 19% on groceries by using a supermarket rewards card. "If I save 19%," he says, "then I make 19%. I count my blessings and don’t worry about what the bank offers in interest rates."

Mr. Alleman’s point of view is a reminder that there’s more than one way to boost the return on your savings. Another option, albeit a riskier one, is to invest money in the stock market that you don’t need right away. That, in fact, is what Claire and Zach decided to do. They left enough for an emergency cushion in their savings account and divided the rest among four mutual funds, including two index funds and two actively managed funds, one of which is Homestead Small-Company Stock. The Homestead fund is a member of the Kiplinger 25, the list of our favorite mutual funds.

Their strategy of combining index funds with actively managed funds is spot-on. The index-versus-active debate flared anew last year, when only 10% of actively managed stock funds that focus on big U.S. firms beat Standard & Poor’s 500-stock index. In her story on the Kip 25, senior associate editor Nellie Huang reports that active funds suffered last year mainly because large-company stocks beat midsize, small-company and foreign stocks.

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That’s not likely to continue. “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,” writes Nellie.

That spells opportunity for active fund managers, and the Kip 25 attempts to spot the funds that can capitalize on it. Among the things we look for, low fees top the list. That’s the best way to compete with index funds, whose low costs give them an advantage. For example, all three funds that are new to the Kip 25 this year have expense ratios that are lower than the average among funds in their class. One of those funds, T. Rowe Price Diversified Small-Cap Growth, replaces Baron Small Cap, cut from the list because, in Nellie’s view, its expense ratio of 1.30% is too high given its $5 billion in assets.

How should you combine index and active funds among your investments? Keep the core of your portfolio indexed, advises investing icon Burton Malkiel. That could mean as little as half if you feel financially secure, or as much as 90% to 95% “if you’re on the edge of not having enough to retire.” With the rest, we suggest that you take a look at the Kip 25.

Who’s legit? Paying for investment advice is a recurring theme in this month’s issue. In Rethinking Retirement, senior editor Jane Bennett Clark tells how to avoid being scammed by “advisers” who pitch fraudulent financial advice to seniors. In Ahead, senior editor Anne Kates Smith delves into the debate about whether brokers who sell retirement products should meet a fiduciary standard. Anne offers her own solid advice on how to avoid high fees and find an adviser you can trust.