Four funds join the Money 70

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NEW YORK (Money Magazine) -- Sometimes the best portfolios have to change, even the Money 70.

In putting together our list of recommended funds, we look for a consistent strategy, expenses that are no worse than average and long-term performance in the top half of a fund's peer group.

We'll still keep a fund on the list if performance slips but we have confidence in management.

We don't jump in and out of funds, and neither should you.

Nevertheless, this month we're replacing four Money 70 funds. Two are now closed to new investors. Two others received mediocre grades from Morningstar when the rating firm tightened its standards for how funds should treat shareholders.

The closed funds are Royce Opportunity, a small-cap value fund, and SSgA Emerging Markets, which buys stocks in developing countries.

Typically, funds close when the type of stock they own has been hot, investors have been pouring in and the managers feel that having more money to invest would impede their performance. That's the case here, so this is a step current holders should welcome.

It's also a cautionary signal about plowing a lot of cash now into their Money 70 replacements.

We don't design the Money 70 as a way to chase returns in a (temporarily) hot sector. Instead, use the list as a way to put together a sound, low-cost, diversified portfolio. That said, here are the closed funds' substitutes:

Bridgeway Small-Cap Value (BRSVX) Like its sibling Bridgeway Aggressive Investors 2, another Money 70 entry, this $300 million fund is run by lead manager John Montgomery, who uses computer models to select stocks based on criteria such as cash flow, financial strength and price appreciation.

The results tend to be bumpy, annual returns have alternated between the top and bottom of the fund's peer group, so don't choose this fund if you can't stand some stumbles. But over the past three years, Small-Cap Value has ranked in the top 1% of its category.

American Funds New World (NEWFX) Full disclosure: This fund is not a pure emerging markets play.

Roughly half of the fund's $16.6 billion in assets is stashed in companies from mature markets that earn much of their revenue from operations in developing nations. The other half is invested directly in emerging markets stocks.

This strategy means New World lags when developing markets soar, as they have recently. But the fund is also less risky; in 2000, New World gave up just 20% vs. a 30% average loss for its category.

After the recent run-up in emerging markets stocks, holding a lower-risk option makes a lot of sense. (Note that unless you buy this fund in a 401(k), you'll likely pay a sales charge.)

We're also replacing two funds that fell short under Morningstar's tightened "stewardship" standards. Neuberger Berman Fasciano, a small-cap growth fund, and Aston Mid Cap received Cs under the new criteria, and we look for Bs or better.

Among the issues: Neither fund has a board chairman unaffiliated with its management, which Morningstar views as the best way to avoid conflicts of interest. And in grading expenses, Morningstar has begun using narrower peer groups to compare funds, which can make it more difficult to get a high score.

Neuberger Berman Management president Peter Sundman is critical of the new methodology. "There's no evidence that independent chairmen are better defenders of shareholders," he says, "and we have issues with the peer-group comparisons Morningstar used for expenses." The Aston fund company had no comment.

My own take: Morningstar's changes are for the better, but there's no reason to sell these funds.

Nothing has changed at the funds, and they're run by good managers. On the other hand, there are good potential replacements that clear Morningstar's hurdles.

Royce Value Plus Service (RYVPX) The odd name is an (awkward) attempt to reflect the fund's strategy, which is to buy inexpensive "value" companies with rapidly increasing earnings (the "plus" part).

The $3 billion fund ranks in the top 1% of the small growth category over the past five years. Says lead manager Chip Skinner: "We often find broken growth companies and wait for them to turn around."

Recently the fund's largest stakes included Ivanhoe Mines, an international mining company, and Knight Capital Group, a financial services firm.

Fairholme (FAIRX) This $5 billion fund is classified as midcap, but the managers don't stick strictly to mid-size companies. They simply buy 25 or so stocks that they deem to be great businesses selling at discounts to their real value.

Top holdings: Warren Buffett's Berkshire Hathaway and Canadian Natural Resources, an oil and gas developer.

Together they account for a third of the fund's holdings; that kind of concentration can make for volatile returns. But Fairholme has outpaced 70% of its peers since 2002.

About 20% of the fund's assets are in cash, says co-manager Larry Pitkowsky, "so we can invest in any opportunities that come along." Fairholme presents a good opportunity itself.