The Best Mutual Funds

In a tough year, surefooted managers keep going strong

Many mutual-fund investors don't know which way to turn. Little wonder: After every quarter of gains in the past two years, the market has come right back with three months of devastating losses. And the obvious strategies of exploiting gaping disparities of value--between large-cap and small-cap stocks, for example, or between growth and value stocks--have run their course as the differences have narrowed. Even the superior returns of bonds over stocks in the past couple of years are unlikely to be repeated soon.

So what should investors do now? The worst tactic is to sit on the sidelines, even if "you're so terrified that you have to pick your stomach off the floor," says Mary Lisanti, chief investment officer for domestic equities at ING Pilgrim Investments Inc. "That's what buying low is all about."

And that's where our Mutual Fund Scoreboard comes in. If you're searching for funds with solid track records and seasoned managers, the 17th edition of the Scoreboard is a good starting point. It is prepared for BusinessWeek by Standard & Poor's (both are owned by The McGraw-Hill Companies). We've sifted through a database of 3,493 equity funds and found an elite group that produces the best returns for the least risk. Only 150 in total--fewer than 1 in 20 funds--make the cut and earn our overall A rating. Others get the top grade for being among the best funds in their category.

The A-rated funds are the pick of the long-term buys. They're not surefire winners year in and year out, but they have the best risk-adjusted returns over five years. How do we know? We've adjusted each fund's pretax returns for the amount of risk the manager ran to achieve the results. Month by month, over five years, we check whether the fund managed to beat the risk-free return on Treasury bills. Each time it fails, it earns negative marks. The bigger the sum of the negative numbers, the higher the fund's risk of losses.

Results for the 605 largest funds start on page 70. Ranging from the $79 billion Fidelity Magellan Fund to the $596 million Templeton Global Smaller Companies Fund, they represent almost 90% of the assets of all the funds in our database, shown in its entirety online at The online returns--and ratings--are interactive and updated monthly.

The A-list runs the gamut from the racy to the reserved, reflected in five levels of risk ratings, from very high to very low. If you're game for a wild ride, you might choose one of only two tech funds that won top scores this year. The Kinetics Internet Fund earned a 36% annualized return over five years, the highest of all the A-rated funds. Although the payoff has been spectacular, investors have been whipsawed: The fund earned 219% in 1999 but lost 51.5% the following year, making it the only A fund to get a "very high" risk rating. Since then, the managers have toned down their stock picks by buying household names, such as Washington Post Co. (WPO ) and Liberty Media (LMC.A ), AT&T's (T ) spin-off. Last year, the fund lost 9.6%--about a third as much as its peers.

Most of our A-list funds are at the other extreme, with low or very-low risk levels. Three funds run by Wells Capital Management, a unit of Wells Fargo Bank (WFC ), are practically on autopilot, racking up annual returns of between 8.6% and 11.7% over five years: Growth Balanced, Moderate Balanced, and Strategic Income. These funds invest in other Wells funds run by a variety of managers. They start with preset allocations of stocks and bonds, then use computer models to vary the mix. The aim is to create a smooth ride. By contrast, "if you go with the star-manager system, you may have better years," says Wells' Director of Asset Allocation Galen G. Blomster, who designed the models in 1989. "But you'll have more volatility."

Many managers of top-rated funds have earned their stripes by taking the road less traveled. Consider Franklin Resources' Mutual Series funds, which had a hard time attracting and keeping investors in the late 1990s. With the return to favor of value investing, the funds' long-term track record has shown through, and a handful have A ratings. "Now investors realize they were throwing away real businesses for get-rich schemes," says Chief Investment Officer David Winters. He and his team select stocks using the same criteria they have for the 15 years that he has been with Mutual Series. Often, they get their best investment ideas from the market's daily new-low list. His team is especially keen on unloved or deeply discounted stocks, such as bankrupt California utility Pacific Gas & Electric (PCG ) and companies grappling with restructuring pains, including E.W. Scripps (SSP ), Federated Department Stores (FD ), and White Mountains Insurance (WTM ).

Many of the best-performing funds are all-weather affairs that excel no matter what the market climate. Their managers are rarely content to follow the pack, which is currently buying up cyclical consumer and industrial stocks, anticipating a boom once the U.S. economy kicks into gear. Scott B. Schermerhorn, the manager of two A-rated funds--Liberty Growth Income and Liberty Utility--says he doesn't bank on a hope and a prayer for future returns. "I'm buying stocks that are paying us today, vs. trying to speculate what a company is going to make three or four years from now," says Schermerhorn, who manages $3.5 billion in large-cap value stocks for Fleet Asset Management. He likes such stocks as Allegheny Energy (AYE ), a diversified utility company that pays a 4% yield while expanding earnings a modest 6%. Unlike other utility managers, who loaded up on emerging telecom-related issues, Schermerhorn stayed away--and he's still bearish on the sector.

The Scoreboard's details of cash holdings highlight which managers have full faith in the U.S. stock market. Lately, some have more stashed away in greenbacks than in stocks. "It's better to spend time avoiding problems than trying to find that big winning stock," argues Manu P. Daftary, manager of the $360 million Quaker Aggressive Growth Fund. In 1999, when the bull was raging, he had 60% of the fund's assets in cash. Yet the fund surged 99% that year because two-thirds of its investments were in tech stocks, such as Check Point Software Technologies Ltd. (CHKP ) and Powerwave Technologies Inc. (PWAV ) Last year, Daftary was as much as 90% in cash but halved that in the fourth quarter when he bought beaten-down tech and drug stocks, such as Abbott Laboratories (ABT ), Rational Software (RATL ), and Network Associates (NETA ), betting "a little bit early" on an eventual tech-sector rebound.

It helps to know which funds make big concentrated bets, too. You can find that information in the Scoreboard, which gives the percentage of assets accounted for by a fund's top 10 stocks. Mutual-fund managers who buy a limited number of stocks expose investors to more risk. Sandi L. Gleason, co-manager of the Kayne Anderson Rudnick Small Mid Cap Fund, for instance, makes big bets on a few small and midsize companies. But companies in her portfolio are expanding earnings at a healthy 18% annual clip--even though she looks mainly for even-keeled results. "We're not seeking the fastest-growing companies, or the cheapest," says Gleason, whose A-rated fund has about 40 stocks, including IMS Health (RX ), a market-data company, and low-cost financial-services outfit National Commerce Financial (NCF ). "We're looking for steady growth."

Even if their investing style is out of favor temporarily, A-rated funds often make a strong comeback in the long haul. Funds that buy health-care and biotech stocks, for example, were down an average 12.5% last year, after whirlwind gains of 55% in 2000. So there's a chance to buy longstanding winners, such as A-list stalwart Eaton Vance Worldwide Health Sciences fund, on the cheap. The fund has an annual 23.4%, five-year return, though it faltered with 6.6% losses last year. Manager Samuel D. Isaly balances the fund's holdings between fledgling and mature companies, mostly based in the U.S. He forecasts a performance surge in the next few years as the Food & Drug Administration--which dragged its heels with drug approvals last year--gets its act together. "There's a record backlog" of potential drugs to hit the market, he says. William Muggia of the Touchstone Emerging Growth Fund also is bullish on the health sector, betting a third of the fund's assets on biotech, health-service, and medical device stocks. His A-rated small-cap fund's annual return is 22% for five years.

Investors with a contrarian bent also can scour the A list for global funds with solid five-year records that have hit hard times. "The biggest advantage is that [those] markets are less expensive," says Nicholas P. Sargen, a global strategist at J.P. Morgan Chase & Co. He argues that although the U.S. market may be the first on its feet, Europe may zoom higher and faster, since stocks there never got as frothy. Two top European funds are Merrill Lynch Euro Fund and Mutual European. Other A-rated funds have excelled in riskier emerging markets, including the $250 million OppenheimerFunds Developing Markets Fund. "One cause of failure is being afraid to fail; you have to take judicious chances," says its manager, Rajeev Bhaman, who has earned an annualized 17.6%, three-year return. He too has a strong contrarian streak. Other managers are now piling into surging Russian and Chinese markets, but Bhaman sees too much political and financial volatility. Instead, he's buying utility and consumer stocks in India and Korea, where "incomes are rising and people are in consumption mode."

Since management fees come right out of an investor's pocket, it's critical to monitor them during down markets. We also track that in the Scoreboard. The average expense ratio is 1.42%. Recent S&P studies show that the higher fees a fund charges, the worse it tends to perform.

Although there's a growing debate about how mutual funds should be taxed in the future, investors must live with the rules for now. The Scoreboard lists untaxed capital gains--and losses--for funds. This can help investors avoid tax bills on those funds with big existing gains or get a free ride on potentially well-performing funds with big carry-forward losses. Also, pre- and aftertax total returns for the past one, three, five, and ten years are provided where available. That's a useful tool to help you figure out whether you have got the appropriate funds in either taxable or tax-sheltered accounts.

The Scoreboard also gives each fund's average price-earnings ratio, a stock-valuation measure that shows how sensitive a manager is to paying steep prices. As usual, you'll find data on assets under management and sales charges. Manager changes also are highlighted: While a fund may have had stellar results in the past five years, a departure could give an early signal of trouble ahead.

An economic recovery and a rebound from one of the worst-ever corporate profit slumps are surely in the cards. But with no clear road map to the markets so far, "it's going to be a lot tougher from here on in," says Franklin's Winters. "You're going to have to turn over a lot of stones." BusinessWeek just made that process a whole lot easier. Read on.

Corrections and Clarifications In "The best mutual funds" (Special Report, Jan. 28), the Mutual Fund Scoreboard was incorrect in indicating that the management team for the Vanguard U.S. Growth Fund had a 10-year tenure. The subadviser, in fact, was changed in June, 2001. Also, the largest holding of the Vanguard Star Fund is Vanguard Windsor II, not the Vanguard International Growth fund.

By Mara Der Hovanesian in New York

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