(MONEY Magazine) – Michael Schonberg is a man on fire. Schonberg, 45, runs Dreyfus Aggressive Growth, the hottest diversified mutual fund around. His $154 million meteor returned 50.9% in the first six months of this year. And he's not alone. Flaming too is James McCall (right), whose PBHG Core Growth rose 38%. And then there's Garrett Van Wagoner, a veritable human torch. He runs three funds that each returned 35% or more between New Year's Day and July 1. In a first half that saw the average diversified U.S. stock fund post a healthy 10.8% gain, no fewer than 68 such funds, almost all of them small-company and aggressive growth entries, racked up astounding advances of 30% or more. And such dazzling numbers hardly went unnoticed. Over the first half of the year, investors poured a staggering $24 billion into small-company and aggressive growth funds.

Now let's get real: As most--but not all--investors surely know, such superheated returns are simply not sustainable. In the long run, some of these pyrotechnic portfolios will merely cool off, while others surely will blow out as swiftly as candles in a summer storm. In either case, the people piling into these funds with visions of doubling their money in a matter of months are bound to see their expectations--if not their cash--go up in smoke.

And that's where this story can help. We cast a cold eye on some of 1996's hottest funds, telling you which ones are worth the risk and which are simply too hot too handle. We examine the 15 diversified portfolios that, according to Lipper Analytical Services, had the best year-to-date records as of June 1. (If a manager had more than one fund among the leaders, we treated his funds as one entry, focusing on the top performer; the secondary funds are noted in bold type below. We also excluded gold and sector funds because they are inherently prone to soar one quarter and plummet the next.) Then, to provide alternatives to the riskiest of these high fliers, we profile 10 steady performers that can help fireproof your portfolio.

In June, investors got a hint of what the future may hold for the hottest of the hot. That month, in what can only be called a June swoon, small stocks--the main fuel for this year's flaming funds--lost 4% of their value (as measured by the Russell 2000 index). Many of the top-performing funds fell even further (we note their June losses below).

To understand what makes these funds so volatile, you have to look at the relationship that has developed between the funds and the stocks they owned. It becomes a kind of self-perpetuating money machine. The mechanism: With tons of fresh cash rolling in, managers tossed money at virtually any firm--the smaller, the better--that looked like it might become the next Microsoft. Any outfit that could claim a connection to the Internet was especially attractive. The more cash that was pitched, the more the stocks rose, the better the fund did and the more the cash flowed in--all to be funneled right back into the same hot stocks. (For a closer look at six stocks that helped fuel the fund boom, see page 82.)

Thus the stocks owned by many of the hot funds in this article are priced as if they were the last remaining shares on the planet. We analyzed the top 10 holdings of these funds (except Van Wagoner's, which released only their top five) and found that at the end of May they traded at a giddy 132 times their earnings for the past year, vs. a price/earnings ratio of 19 for the stocks in the Russell 2000.

Moreover, many of these funds haven't been around long enough to establish a meaningful track record. Of the 15 blazing funds discussed here, nine are less than a year old. And as I detailed in Money's July issue, several factors may help new funds get off to an artificially fast--if not always durable--start. (By the way, you won't find those nine newborns in our first-half performance report beginning on page 92; funds must be at least one year old to make our cut.)

All this explains why it's so important to approach these fire breathers with extreme caution. I've summarized the riskiness of each portfolio (discussed below in order of their 1996 gains to June 1) with a device I adapted from my local Thai restaurant, where the spiciest food is branded on the menu with four dragon tongues in the shape of flames. Funds with three or four flames are suitable only for investors willing to take big risks in hopes of getting big returns. Funds with one or two flames may make sense for more cautious investors. Key data for the hotshot funds as well as the Steady Eddies, including their top stockholdings and total assets, appears in the table on page 85. Portfolio holdings and valuations are as of May 31.

[Three flames] DREYFUS AGGRESSIVE GROWTH. Up 50.9% in the six months to July 1. Off 11.4% in the June swoon. Manager Schonberg launched this small-company fund in September of '95. Half the 10 top holdings in this 70-stock portfolio had no earnings in the past year. "Often, the best investments can be companies whose future earnings you can't really know exactly," he says. "You just see they're going to grow extremely fast." Schonberg also runs Dreyfus Premier Strategic Growth (six-month gain: 17.9%; June loss: 14.9%), sold through banks and brokers with a 4.5% sales charge. Schonberg is tough, experienced and flexible, but these funds are three-alarm jobs, for serious risk-takers only.

[Three flames] JUNDT U.S. EMERGING GROWTH. Six-month gain: 49.8%. June loss: 9.9%. Manager James Jundt, 54, wasn't overly impressed by his 67% return through May. "We've been managing growth-stock money since 1969, and we've had bigger years," he says. Launched last December, this 4%-load fund is still getting the new fund boost. Jundt owns 30 to 50 companies; at least half have revenues of $250 million or less. Four of his top 10 stocks had no profits at all; the other six trade at an average of 103 times earnings. Note too that Jundt Growth, formerly a closed-end fund, fared poorly in 1993, returning 0.2% while many growth funds were up 20% or more.

[Three flames] VAN WAGONER EMERGING GROWTH. Six-month gain: 49.7%. June loss: 4.4%. Garrett Van Wagoner, 40, went out on his own this January after leading $519 million Govett Smaller Companies to a 54.7% compound annual return during his two-year, nine-month tenure. He achieved that amazing record partly by trading like an NBA general manager on draft day. His portfolio turnover at Govett ran as high as 519% (nearly four times the average fund's)--meaning he held his typical stock for just 10 weeks. But his half-year-old fund family already has $1 billion. And I think Van Wagoner's size will make it harder for him to zip in and out of stocks as nimbly as he did at Govett. On average, his top stocks trade at 106 times last year's earnings. "Great businesses are expensive," says Van Wagoner. He applies a similar philosophy to Van Wagoner Micro-Cap (up 35.8% for the first half; off 4.4% in June) and Van Wagoner Mid-Cap (up 36%; off 3.6%). Van Wagoner is talented, but be warned: He thinks 15% annual returns from now on would be "heroic."

[One flame] DREYFUS PREMIER GROWTH & INCOME. Six-month gain: 44.2%. June loss: 0.1%. Veteran economist and money manager Richard Hoey, 53, runs this 4.5%-load fund, which is a clone of Hoey's five-year-old no-load Dreyfus Growth & Income. Launched in December, it's still getting a lift from the new-fund effect. But note: Hoey also got off to a steamy start with Growth & Income--only to cool as that fund's assets grew past $1 billion. In both funds, Hoey largely steers clear of riskier, higher-priced small stocks in favor of steady blue chips and convertible bonds. If you buy your funds through a bank or broker, this is a sound low-risk choice. Otherwise, stick with the older no-load version.

[Three flames] NEEDHAM GROWTH. Six-month gain: 41.5%. June loss: 1.9%. Another December '95 baby, this fund owns about 50 stocks averaging $2.5 billion in market capitalization. Manager Howard Schachter, 50, favors technology, health care, and specialty retailing firms. His top 10 stocks sell at 68 times the past year's earnings, and their growth rates even higher. Schachter, though, says he is not looking for quick hits: "I want to build a long-term track record." To cut risk, he limits his top position to 3% of assets; he also hedges by raising cash (now 25%) and buying put options on sector indexes--essentially, betting certain industries will slump. Schachter is highly skilled and experienced, but his heavy cargo of high-priced stocks will make for a bumpy ride.

[Two flames] PBHG CORE GROWTH. Six-month gain: 38%. June loss: 3%. Stablemates PBHG Growth and PBHG Emerging Growth became famous investing in fast-growing small stocks. But at Core Growth, launched in January, manager James McCall says: "We'll invest in any growth company regardless of size." McCall, 42, owns around 75 stocks ranging from giant Pfizer ($46 billion market value) to tiny Datastream ($286 million). The fund's typical stock trades at about 44 times the past year's earnings. Its larger stocks make it less risky than its small-company siblings, and the firm has shown a mastery of earnings-momentum investing, so Core Growth comes out as a safer bet in this group.

[Three flames] LANDMARK SMALL CAP EQUITY. Six-month gain: 37.9%. June loss: 3%. This one-year-old fund is sold through Citibank and brokers with a 4.75% sales charge. Manager David Pearl, 37, holds about 55 fast-growing small stocks (median market value: $230 million), especially technology and energy firms. "I try to find these things before others do." he says. "In the inefficient small-cap market, my knowledge pays off." But many of Pearl's picks are well-known enough to sport very high P/E ratios. And the sales load here is a high price to pay for Pearl's wisdom.

[Two flames] FONTAINE CAPITAL APPRECIATION. Six-month gain: 19.7%. June loss: 15.7%. Manager Richard Fontaine, former skipper of T. Rowe Price Capital Appreciation, aims to beat inflation and minimize risk. His investors don't have to worry about a collapse in tech stocks: There are no Internet or computer networking stocks here. Instead, roughly 54% of assets are in mining companies that have benefited from this year's inflation jitters. But if those fears recede, so may this fund. And some of Fontaine's mining stocks are obscure firms with overseas operations that are not exactly rock solid--as his June swoon shows.

[Four flames] NAVELLIER AGGRESSIVE GROWTH. Six-month gain: 30.6%. June loss: 7.1%. Newsletter writer Louis Navellier, 38, launched this fund in (guess when?) December. Says current manager Alan Alpers, 33: "We try to figure out what's working well on Wall Street." Right now, Navellier's computer models say stocks are getting the biggest boosts from two factors: rapidly growing profits and rising earnings estimates from Wall Street analysts. Aggressive Growth's top 10 holdings trade at 60 times the past year's earnings; at its older sister fund, Navellier Aggressive Small Cap Equity (six-month gain: 27.6%; June loss: 8.1%), the top 10 stocks sport a frightening P/E of 136. Alpers candidly warns that if Aggressive Growth had been running in the first half of 1994, it would have lost 20% of its value with its current investment strategy (vs. a 6.4% loss for the Russell 2000). If you want to buy either of these funds, strap on your asbestos long johns first.

[Two flames] FREMONT U.S. MICRO CAP. Six-month gain: 32.4%. June loss: 3.8%. This fund is run by Robert Kern, 60, who has been managing small-cap stocks since 1969. Kern owns about 70 very small stocks, most with market values under $265 million. "We ask, 'Would a rational businessman put hard dollars down to buy this company at the market value of the stock?'" says Kern. "If the answer's no, we pass." This fund is two years old, but an earlier microcap account run for Bechtel by Kern lost only 0.5% in 1990, vs. the Russell 2000's 19.5% bloodbath. Microcap stocks are always risky, but Kern's experience and sensible approach make this a relatively temperate choice.

[Two flames] MONTGOMERY SMALL CAP OPPORTUNITY. Six-month gain: 31.7%. June loss: 4.1%. Here's another six-month-old fund. This one is run by Michael Carmen, 34. Carmen owns five dozen stocks and, like Kern, he's a careful shopper. "We want stocks selling at a reasonable price," he says. "Having a valuation discipline is the best thing we can do to control the risk of the portfolio." Carmen's typical stock has a market value of $775 million and is priced at about 30 times the past year's earnings--both moderate numbers by the standards of this group. This fund should prove a good long-term performer.

[Two flames] LINDNER BULWARK. Six-month gain: 32.7%. June loss: 2.7%. Managers Eric Ryback, 44, Bob Buettner, 31, and Lawrence Callahan, 34, aim for "capital appreciation during periods of economic distress," picking investments "intended to protect against the erosion of the value of financial assets," according to their prospectus. That means, among other things, lots of gold-mining stocks, other commodities like uranium, and real estate investment trusts. Like Fontaine Capital Appreciation, this fund is getting a boost from inflation worries. Bulwark's contrarian style can be useful when you're building a diversified fund portfolio; it will never get you rich by itself.

[Four flames] FRONTIER EQUITY. Six-month gain: 31.4%. June loss: 2.9%. Wisconsin-based broker Jim Fay founded this tiny 8%-load fund in 1992. Of the fund's 10 top stocks, nine failed to report positive earnings in the past year; the other is priced at 195 times earnings. While the typical company in the Russell 2000 small-stock index sells at 1.24 times annual revenues, Frontier's top 10 stocks sell at a vertiginous average of 20 times sales. And the top two holdings--Erox and Mitek Systems, each with minuscule total market values of less than $70 million--make up nearly 25% of the fund, a dangerously high concentration.

Also troubling: The National Association of Securities Dealers is seeking to fine Fay and his brokerage firm, Freedom Investors, $10,000 over alleged violations of securities rules. (Fay is appealing the decision.) Regulatory questions aside, this fund is simply too hot to handle.

[Three flames] TURNER SMALL CAP. Six-month gain: 29.7%. June loss: 4.2%. Manager William Chenoweth, 35, uses computers to screen stocks on 13 different earnings-growth factors. He seeks to match the sector weightings of the fund's benchmark Russell 2500 index but puts heavy emphasis on picking the best stocks within each sector. The fund generally owns 120 issues, with none permitted to exceed 2% of fund assets. Its typical holding has a market value of $800 million and a P/E of 35. Portfolio turnover runs a hotfooted 170%. "There are so many good ideas I want to add," says Chenoweth, "that I can always cull out my least favorite stocks." Broad diversification helps cool this fund's risk a bit.

[Two flames] WARBURG PINCUS SMALL COMPANY VALUE. Six-month gain: 33.4%. June loss: 0.8%. Lead manager George Wyper, 40, takes both parts of his fund's name seriously. "Small company" means about five dozen tiny stocks (average market value: $180 million). And "value" means cheap stocks; Wyper's typical holding trades for just 12 times its past year's earnings. "We want to find companies that are valuable instead of stocks that happen to be going up," he says. This is another fresh-faced December '95 debutante, but the talented Wyper also co-manages the longer-running market beater Warburg Pincus Capital Appreciation and formerly ran money at Fireman's Fund for Warren Buffett disciple John Byrne. That combination of factors makes Small Cap Value a good bet for the long haul.

No doubt about it, these funds boast astounding short-term numbers. In the long run, though, the short run doesn't count. That's why you ought to consider the following 10 funds. To make it onto this list, a fund had to have the following characteristics: above-average return and below-average risk for at least five years running, low annual expenses and a consistent investment style. And I nixed any fund suffering the sudden, rapid growth in assets that can ultimately sandbag performance. Among these picks (presented alphabetically) are three international funds to help spread your risks.

Acorn. Five-year annualized return to July 1: 20.4%. Lead manager Ralph Wanger has run this outstanding fund for 26 years. Now open to new investors for the first time since 1990, Acorn should be a tasty morsel for investors who want more small-cap exposure.

Davis New York Venture. Five-year return: 19%. Shelby Davis, whom Money dubbed "America's most reliable fund manager" in last December's cover story, buys and holds the cheapest stocks he can find. Venture carries a 4.75% maximum load, but Davis also runs no-load Selected American.

Dodge & Cox Stock. Five-year return: 16.8%. This 31-year-old fund, run by a team of conservative managers, favors U.S. blue-chip stocks at low valuations and holds up well in bear markets.

EuroPacific Growth. Five-year return: 14.2%. One of the oldest foreign funds, founded in 1984, this portfolio (maximum sales load, 5.75%) is run by a large team of research whizzes at Capital Research & Management of Los Angeles.

Fidelity Growth & Income. Five-year return: 18%. Fidelity often uses this fund as a proving ground for its best young pilots; Jeff Vinik got his wings here, as did another ace, Beth Terrana. Current manager Steve Kaye is no slouch.

Janus. Five-year return: 15.4%. Once a nimble picker of smaller stocks, James Craig now runs this giant like a mainstream growth fund. He has shown that he can preserve capital nicely when the market tumbles.

Neuberger & Berman Guardian. Five-year return: 17.1%. Co-managers Kent Simons and Lawrence Marx are connoisseurs of the unfashionable, buying--and profiting from--Wall Street's rejects.

Scudder International. Five-year return: 11%. The oldest foreign fund, founded in 1953, is run by a team that scours the globe for steady growth stocks at bargain prices.

T. Rowe Price International Stock. Five-year return: 12.7%. With remarkable consistency, lead manager Martin Wade has powered this fund past the averages for most of its 16-year history.

Vanguard Index 500. Five-year return: 15.6%. Yes, I know: Who wants a fund run by a machine? You should. Even though it mechanically mimics the holdings of Standard & Poor's 500 stock index, this fund beats the britches off most human competitors year after year. You'll have a hard time finding anything better.

Reporter associate: Malcolm Fitch