Good mutual funds make money in bull markets -- but the best ones also don't lose too much when times are tough. Unfortunately, many equity-fund investors learned that lesson the hard way in the past five years. Sandwiched between the booms of 1999 and 2003 were three exceedingly dismal years for stock-pickers. That's why BusinessWeek's 19th annual Mutual Fund Scoreboard is even more valuable this year. From a list of 3,517 funds, we've identified a select group that earned the best returns for the least risk during these crazy five years. To be rated, a fund must have at least five years' history. We measure each fund's monthly performance for the past 60 months.
When a fund fails to beat the return for U.S. Treasury bills, it earns negative marks, which are then subtracted from the total return. We then rerank the funds on these risk-adjusted results. Only 183 funds ended up on the A list for overall performance. We then reran the ratings for each category of funds, such as large-cap growth, small-cap value, or real estate. The result: 171 funds rated A when compared with their peers. The Scoreboard features all funds with at least one A rating (72 of the funds have two As). An interactive version of the entire Scoreboard can be found at http://bwnt.businessweek.com/mutual_fund/. Next week, we'll look at the best bond funds.
Prepared for BusinessWeek by Standard & Poor's, the Scoreboard also contains important fund details, especially fees and expenses. Those subjects have been grabbing headlines lately, and investors need to pay attention to these costs. Still, our analysis shows there is no strong correlation between highly rated funds and low fees. However, we do find that the worst-rated funds, those getting Fs, usually have the highest expenses. That's in part because funds with poor performance have fewer assets, while high fixed costs eat into the overall returns.
You'll find A-List funds run by management companies that have been swept up in the recent mutual-fund trading scandals. Those include offerings from Heartland Advisors, Janus Capital Group (JANSX ), Invesco Funds (FIIIX ), and Strong Capital Management. If you are considering an investment in one of these companies' funds, proceed with caution. Some of these fund companies have had high redemptions which could hurt fund performance.
The Scoreboard contains data on cash holdings: a position of 10% or more could mean managers are having a tough time putting money to work and may close the fund to new investors. The Turner Micro Cap fund, for example, invests in tiny, illiquid public companies, but the fund closed to new investors in March, 2000, when assets hit $250 million. "In the small-cap arena, your level of outperformance decreases with a higher asset base," says manager Frank Sustersic. Other A-rated funds no longer open include Fidelity Low-Priced Stock (FLPSX ), Wasatch Micro Cap, and Dodge & Cox Stock (DODGX ). But if there's a closed fund you would like to invest in, keep an eye on it: They often reopen, sometimes for very short periods.
Our A list is a starting point -- not a definitive buy list. You need to consider why a fund is on the list. For instance, you'll find high-flying precious-metal funds earning As for overall returns, which isn't a surprise, since gold was a hot sector during the bear market. Such funds, though they can add value to a portfolio, are not core investments.
That's why you need to look for diversified funds that earned competitive risk-adjusted returns in a tough environment such as the A-rated $1.9 billion Jensen Fund (JENSX ). It slightly underperformed its peers in 2003 but outpaced the large-company growth group by more than 10 percentage points, with a 7.7% annualized gain over the past five years. (The Standard & Poor's 500-stock index was negative during this period, with a -0.6% average annual return.) Jensen's highly concentrated portfolio focuses on companies that have delivered a 15% return on equity over the past decade: That narrows the field to about 110. Co-manager Robert G. Millen says this formula hones in on high-quality companies that perform well over the long haul. Among the fund holdings are Stryker (SYK ), a leading maker and distributor of orthopedic implants and other medical devices, and MBNA (KRB ), a credit-card powerhouse. "We have a different mentality from other money managers, who are in and out of companies," says Millen.
UP THE MIDDLE
The scoreboard's data on portfolio turnover will help you identify other funds with a long-term view. Like Millen, Susan I. Schottenfeld, co-manager of the A-rated $816 million TCW Galileo Value Opportunities fund, uses a disciplined process to find investments that may take years to pay off. "We are building a portfolio of turnarounds," says Schottenfeld, who is also co-manager of the A-rated Touchstone Emerging Growth Fund. Her specialty is midsize companies with strong balance sheets and cash flow that are poised for a rebound. One position she has consistently added to for the past few years is retailer J.C. Penney (JCP ). Although the stock has underperformed the S&P 500, she has held on because she sees value in the company's Eckerd drugstore unit. While they work for separate divisions of TCW, Schottenfeld's colleague Diane Jaffee, who runs the $53 million TCW Galileo Opportunity, shares that contrarian approach. And like many other A-team members, she won't buy a stock just because it's cheap or out of favor. "The reason we avoided the Tycos (TYC ) and Adelphias is because we focus on historical valuations," including price-to-book, price-to-cash-flow, and price-to-sales, Jaffee says. That helped her avoid financial stocks and instead led her to invest almost 20% of the small-company value fund in beaten-up basic material stocks such as copper producer Phelps Dodge (PD ). Now she's taking profits in those industrial stocks.
Diversification is key. The A-rated $200 million Al Frank Fund (VALUX ) owns more than 400 stocks in a multitude of industries. The eclectic value portfolio runs from deep cyclicals like recycler Wellman (WLM ) and aluminum giant Alcoa (AA ) to tech companies like Apple Computer (AAPL ), Novell (NOVL ), and American Software (AMSWA ). What they have in common, says co-manager John Buckingham, is strong balance sheets and, for many, a large wad of cash. The fund earned 24% on average for the past five years and was profitable in all but 2002.
Diversified funds that fared best in 2003 tended to invest in small, speculative stocks. Large-company stocks -- and the funds that invest in them -- trailed the market in 2003, but many experts think they'll shine in 2004. John C. Thompson, manager of the $964 million Thompson Plumb Growth Fund, says there is "much more value in the biggest and bluest chips." That's why you'll find Pfizer (PFE ), Freddie Mac (FRE ), American International Group (AIG ), and Johnson & Johnson (JNJ ) in his portfolio.
Blue chips are also enticing investors overseas. David Herro, portfolio manager of A-rated Oakmark International and Oakmark International Small Cap, seeks them abroad. He shies away from speculative emerging markets in favor of established global pharmaceuticals such as Takeda Chemical Industries, GlaxoSmithKline (GSK ), and Aventis (AVE ). "Drug pipelines are improving, the population keeps growing older [and less healthy], and share prices are very, very low," Herro says. "All three of [these stocks] fit our value criteria: They sell at a low price and have a good-quality cash-flow stream."
Managing risk in international funds can be tricky. First, there's currency risk, but that has helped returns lately as the dollar sank. In addition, details on some companies are hard to come by, and trading in smaller markets can be difficult. "When the music stops, you don't want to end up holding something illiquid. [You] can't get out of these things for love or money," says Julian Mayo, co-manager of the A-rated U.S. Global Investors Eastern European Fund. That's why he invests mostly in the bigger companies in his markets.
In less familiar markets, having a pro watch your money really counts. Mayo's fund is only six years old, but he has been an emerging-markets specialist for 12 years. The Scoreboard uses a darkened head-and-shoulders icon to recognize managers with at least a decade's experience. (The outline version of the icon indicates a manager change in the past year.) Among the veterans are the co-managers of Vanguard Primecap Fund (VPMCX ), Howard Schow and Theo Kolokotrones. Samuel A. Lieber, portfolio manager of the Alpine Real Estate Fund, has been at the helm for 10 years.
A manager's long tenure doesn't guarantee a great return. But you might sleep a little better knowing your investment is in experienced hands.
By Lauren Young
With Kate Hazelwood in New York