The Five Best Stock Funds for 2014

Don’t count on the stock market continuing to soar in 2014. The U.S. economy seems to be picking up steam, but compared with historical averages most large-company stocks are somewhat overpriced relative to earnings and revenues. Most small companies are richly priced; stocks in developed Europe and emerging markets are cheaper, but they face stronger economic and political headwinds.

What to do? For the most part, you should stick with blue chips, both here and in established overseas markets. Not only are they less expensive, but they’ll also likely hold up much better in selloffs. The one exception: Emerging markets. While most are troubled, their economies remain the world’s fastest-growing, so they offer potential for superior gains.

With that in mind, here are my favorite stock funds for 2014. I’m making just one change from my recommendations for 2013. As a group, they aren’t intended to keep pace in a bull market. But I think that the funds will hold up relatively well in bear markets. No one knows when the next bear market will occur, but I think that a key to building wealth is to minimize the crushing losses such markets can bring.

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FPA Crescent (symbol FPACX) is almost good enough to serve as your only fund. Lead Manager Steven Romick has piloted Crescent since its 1993 launch, and he has largely met his goal of providing stock-like returns while not losing money. Over those years, the fund returned an annualized 11.1%—an average of 2.1 percentage points more than Standard & Poor’s 500-stock index. And Crescent achieved those results with 30% less volatility than the index. No stock-focused fund, Crescent included, could avoid losing money during the devastating 2007-09 bear market. But Crescent surrendered only 27.9% during the conflagration, while the S&P 500 plunged 55.3%. (Crescent is a member of the Kiplinger 25.)

Romick typically keeps less than two-thirds of Crescent’s assets in stocks. And because he sees few bargains in the market today, he currently has only 52% in stocks, almost all of them large companies. Romick isn’t too keen on bonds, either, so he has more than one-third of Crescent’s assets in cash. Not surprisingly, given the stock market’s ferocious advance, Crescent’s return this year of 19.1% has lagged the S&P 500 by 8.4 percentage points. (Unless otherwise stated, all returns in this article are through December 11.) One drawback is Crescent’s 1.16% annual expense ratio. It’s not outrageously high, but it could be lower.

Harbor International (HIINX) is proof that a talented manager can teach good investment discipline to his successors. Hakan Castegren piloted Harbor International successfully for more than 20 years before his death in 2010. The fund’s four co-managers all worked with him for years.

Harbor International, up 11.1% so far this year, is trailing the MSCI EAFE index, which measures stocks in developed foreign markets, by 5.6 percentage points. But over the past five years, the fund returned an annualized 13.8%, beating the index by an average of 1.4 percentage points per year.

Once Harbor’s managers buy a stock, it tends to stay in the fund for a long time—typically about ten years. The fund owns mostly large companies in developed markets; just 4.5% of assets are in emerging markets. One negative: Unlike every other fund in this article, Harbor International is slightly more volatile than its benchmark index. Expenses are 1.14% annually, low for a foreign fund.

Parnassus Equity-Income (PRBLX) bills itself as a socially responsible fund. But whether or not you lean that way in making your investing choices, you won’t go wrong with this terrific fund. Over the past ten years, lead manager Todd Ahlsten has steered Parnassus to an annualized 9.5% return—an average of 2 percentage points per year better than the S&P 500. What’s more, the fund has delivered those returns with almost 15% less volatility than the index. Ahlsten presciently avoided financials before the 2007-09 bear market, and the fund lost only 40.9%. Since 2005, Parnassus has failed to beat the average return of its category (funds that invest in large companies with a blend of growth and value attributes) in just one year (2010).

Ahlsten and Ben Allen, who became co-manager in 2012, look for high-quality companies with sustainable competitive advantages that will hold up well in recessions. About 75% of the fund’s stocks pay dividends. Turnover is about 50% annually, suggesting that the managers hold a stock for two years, on average. Annual expenses are 0.90%.

As far as social responsibility, Parnassus won’t buy firms that get a substantial amount of their revenues from alcohol, firearms, gambling, nuclear power or tobacco. But the managers also give extra points to companies that, in their view, have responsible environmental and labor policies.

Vanguard Dividend Growth (VDIGX) has a narrow strategy, but it is a proven, low-risk one: The fund buys only stocks of companies that have raised their dividends in each of the past ten years. The companies must also pass several other tests designed to ensure that they’ll be able to continue to raise their payouts. Manager Donald Kilbride decides what to buy from this relatively short list.

Don’t confuse this fund with a high-yield fund. Dividend Growth yields just 2%. It’s filled with large blue-chip companies with durable competitive advantages—companies such as McDonald’s (MCD) and United Parcel Service Class B (UPS). The fund typically holds stocks for five to ten years.

Dividend Growth has posted superb results. Over the past ten years, it returned an annualized 9.1%, topping the S&P by an average of 1.7 percentage points per year. Yet the fund has been 20% less volatile than the S&P, and it lost 42.3% in the 2007-09 meltdown. As is typical of Vanguard funds, Dividend Growth charges an investor-friendly fee of 0.29% per year.Like all broad-based emerging-markets stock funds, Vanguard Emerging Markets Stock Index (VEIEX) has trailed the U.S. stock market badly over the past three years. The Vanguard fund lost an annualized 2.2% during that stretch; the S&P gained 15.3% per year.

Why bother with emerging markets? Because, for all their problems, they’re still the fastest growing economies in the world. Over the past ten years, this fund returned an annualized 10.9%, an average of 3.5 percentage points per year more than the S&P.

What’s more, emerging markets are cheap. The MSCI Emerging Markets index trades for just 11 times estimated earnings for the coming 12 months. By contrast, the S&P 500 trades at 15 times estimated year-ahead profits.

I prefer low-cost index funds for emerging markets because the costs of trading in emerging markets are much higher and the dangers of losing out to unscrupulous brokers and company insiders are enormous. The Vanguard fund boasts a 0.33% expense ratio. If you can invest $10,000 or more, the fund’s Admiral share class (VEMAX) costs just 0.18% annually.

As far as allocation, I’d put 15% of your stock money in Harbor International, 10% in Vanguard Emerging Markets and 25% in each of the other three funds.

How did my 2013 picks do? On average, the funds have returned 17.5% so far this year, compared with 27.5% for the S&P. The laggard was Harding Loevner Emerging Markets (HLMEX), which beat the MSCI Emerging Markets index by 4.4 percentage points but still returned just 2.1%. For investors who want an actively managed fund, this one is tops. (Harding Loevner is a member of the Kiplinger 25.)

Steven T. Goldberg is an investment adviser in the Washington, D.C., area.