The Money 65
Betting on which funds will soar in '06 is a loser's game. So be a winner: Buy what will serve you in the long run. Start looking right here.
By Walter Updegrave

(MONEY Magazine) – This time of year it's not hard to find what looks like a quite promising headline: "The Best Mutual Funds for 2006." Who wouldn't want to know that? Dig into the story, however, and you soon realize that it's pretty much just a more or less educated guess (likely the latter) about whether last year's hot performers will be this year's winners. Folks, that's not investing. That's horse racing.

Investing is about putting together a group of solid, well-diversified holdings, adding to them over time and eventually reaping the rewards of your persistence. Leave the handicapping to the grandstand crowd. Those people in the private boxes got there not by gambling but by investing.

That's what MONEY's recommended list of mutual funds is about. We focus not on what's hot but on what offers you the best chance for long-term success. That means we look for funds that charge minimal fees, that stick to an investing style and that put shareholder interests ahead of the fund managers' bonuses. Take care of those things, and performance tends to take care of itself. So it's no surprise that the overwhelming majority of our funds have beaten most of their peers over three and five years. Coupled with a sound asset-allocation plan (for examples, see "Fix Our Mix" on page 78), these funds will likely have you coming out a winner by more than a nose.

This year we've expanded our list, to 65 offerings from 50, to take advantage of two popular, relatively new investments that can make it easier to put together a sound portfolio: exchange-traded funds (ETFs) and target-date retirement funds.

If you don't already own them, you've probably heard the buzz surrounding ETFs, which, like index funds, invest in a basket of securities such as Standard & Poor's 500. Bought and sold like stocks, ETFs are all the rage. We added them, however, not because they're popular but because they offer ultralow annual expenses and an easy way to diversify, just what you need for a long-term investing plan.

The other new category on our roster, target-retirement funds (also known as life-cycle funds), makes investing about as close to a no-brainer as it can get. You choose a fund with a date close to the year you intend to retire--say, 2035--and you get a diversified blend of stocks and bonds that's appropriate for your age and that becomes more conservative as you grow older. Target funds are becoming the investment of choice in 401(k) plans for people who don't want to build their own portfolios. They're also an equally fine option for IRA rollovers or even for money that's outside a tax-advantaged retirement plan.

While we were at it, we also rounded out our roster of index funds. Our list had been limited to broad stock and bond market indexes. Now, though, you can choose among funds that track the large-company stocks in the S&P 500, as well as mid- and small-cap benchmarks. For additional diversification in international shares, you'll also find an emerging markets index fund, which invests in a basket of stocks from fast-growing markets like China, India and Brazil.

As a result of these changes, you can use the MONEY 65 to create a plan no matter what kind of investor you are. If you like the idea of investing with managers who may be able to deliver superior long-term returns--and you don't mind monitoring their performance--then choose from the table of actively managed funds on page 7. If you prefer to keep things simple and hold costs to a minimum, turn to our selection of index funds or our ETF lineup on page 8. And if you want a laid-back approach that puts your investing plan on autopilot, check out our target-fund listings on the same page.

Whether you're going to put money into the funds on our list or you want or need to look beyond it--among the limited choices available in your 401(k), for instance--you can make good use of the process we used in picking the MONEY 65. What follows is a closer look at how we got here.

ACTIVELY MANAGED FUNDS

In making selections for our original MONEY 50 last year, we eliminated funds with less than $100 million in assets, since they can rack up gains that become unsustainable as they grow. We then tossed out funds that hadn't been run by the same person or team for at least several years, although we made a couple of exceptions when a young fund was run by an outfit that had a great long-term track record. We ruled out funds that have above-average fees and excessive trading, since both can cut deeply into returns. To make sure that our funds put shareholders' interests first, we purged any whose behavior rated less than a B from analysts at Morningstar. (In the few cases where Morningstar had yet to evaluate a fund, we used our judgment.) Only then did we look at performance, focusing on funds that beat 60% of their peers over the past five years (although we made exceptions for specialty funds). In cases where several funds were close, we gave the nod to those with the lowest expenses and most consistent strategy. Funds with low expenses usually win out in the long run, and a consistent investing strategy is important to you if you're assembling a diversified portfolio.

In fact, we cut three small-cap funds from last year's list because their portfolios now hold mostly midcaps. If you own one of them, you now need to be sure your portfolio has enough exposure to small stocks. You can do that gradually by investing new cash in one of the small-cap choices on our list. Or you can direct money to one of our small-cap funds when you periodically rebalance your portfolio. But we also cut funds for performance reasons or because a manager has departed. Does that mean you should too? Not necessarily, especially if selling would result in a sizable tax bill. That said, you should watch the fund closely, and if it lags for more than a year, sell it. (For a list of the funds we dropped, see the table below.)

We ruled out funds that have high fees and trade frenetically, which can cut deeply into returns.

The Funds That We Dropped

Our 2005 picks have performed very well, but we've still had to jettison several over the past year. Here's the rundown.

INDEX FUNDS

We expanded our stable of index funds because their inherent consistency makes them ideal for creating a portfolio or diversifying into specific market segments. Their razor-thin expenses--often more than a full percentage point below what actively managed funds charge--also virtually ensure that they'll outperform most of their peers over the long term. (They can underperform for extended periods, however.) And since they're not constantly buying and selling securities in an effort to beat the market, index funds realize taxable capital gains less often than other funds do. As a result, they pass a lower tax bill on to you.

We restricted ourselves to fund companies that have a history of managing index portfolios and keeping costs down. So it's hardly a shock that index pioneer Vanguard dominates our list. Still, three Fidelity funds cracked it too: Spartan Total Market Index, Spartan 500 Index and Spartan International Index. In a major challenge to Vanguard, all three funds have dropped their annual expenses to as low as 0.10%, well below those of the comparable Vanguard funds. Each requires a minimum investment of $10,000, however, compared with Vanguard's $3,000. For that reason, we included competing Vanguard funds too.

ETFs

The number of exchange-traded funds has more than doubled in the past five years, to nearly 200, giving you the chance to dabble not only in broad indexes but also in esoteric slices of the global market, from Malaysian stocks to nanotech companies. The MONEY 65 is designed to help you build a balanced portfolio, so in selecting ETFs we ignored those that invest in narrow niches. As in choosing index funds, we focused on experienced players and gave the nod to ETFs with the lowest fees.

The result is the 12 ETFs that appear on page 8. You'll find choices in all the categories for which we offer index funds, as well as three areas for which no index fund was available. So if you want an additional hedge against inflation, you can buy a natural resources or TIPS (Treasury Inflation-Protected Securities) ETF. If you're looking to boost the income your portfolio generates, we've included an ETF that invests in an index of dividend-paying stocks.

As compelling as ETFs are, they come with a major hitch: Every time you buy or sell ETF shares, you must pay a brokerage commission. So if you invested, say, $500 a month in an ETF and paid a $10-per-trade commission, you would be giving up 2% of your investment to brokerage fees alone (not counting the cost of selling), wiping out the ETF cost advantage and then some. In short, consider ETFs if you're investing a large sum such as an IRA rollover or a bonus.

ETFs come with a major hitch: Every time you buy or sell shares, you must pay a brokerage commission.

TARGET FUNDS

As we sifted through target-retirement funds, it became clear that sticking to outfits with experience and reasonable fees would yield the three companies that rule the category: Fidelity, Vanguard and T. Rowe Price. Of those, we settled on the Vanguard and T. Rowe Price offerings. Each Vanguard target fund invests its assets in low-cost index funds. Result: No Vanguard offering has expenses of more than 0.21% a year.

T. Rowe's target funds, which invest in a combination of index and actively managed funds, have higher but still reasonable fees. And we liked them because they tend to put a higher percentage of their assets in stocks than other target funds do. For example, T. Rowe's 2025 fund, which is appropriate for people in their forties, stashes 86% of assets in stocks; Vanguard's 2025 fund keeps just under 60% of holdings in equities. Given that Social Security is likely to replace less pre-retirement income for many retirees than in the past, and that pension plans are waning, it makes sense to invest more aggressively than traditional models suggest to build extra retirement wealth. If you prefer Vanguard's low-fee approach but want more stock exposure, choose a Vanguard target fund with a later retirement date, say, the 2035 fund instead of the 2025.

We're not saying that all the funds on our list will always outperform their competitors. But we do know that their low costs and consistent investment approaches give them an advantage. And here's where investing and handicapping a horse race are alike: An edge is a good thing to have.

The low-cost, well-managed funds that appear below and on page 8 are the ideal foundation of a well-diversified portfolio.

Actively Managed Funds

These funds have the best shot at beating the market (but no guarantees).

NOTES: As of Dec. 15. N.A.: Not available. [1] Annualized. [2] 5.75% sales load. [3] 3.50% sales load. [4] 3.75% sales load. SOURCE: Lipper.

Index Funds

Extremely cheap, they're designed to perform as well as the market (but no better).

NOTES: As of Dec. 15. To contact: Fidelity, 800-343-3548; Vanguard, 800-851-4999. [1] Audited and annualized figures, except on Fidelity funds. [2] Annualized. [3] Includes a waiver. SOURCE: Lipper.

Exchange-Traded Funds

Like index funds, but ETFs can be even cheaper if used for large-sum investments.

NOTES: As of Dec. 15. N.A.: Not available. [1] Audited and annualized figures, except on VTI. [2] Annualized. SOURCE: Morningstar.

Target-Retirement Funds

The no-brainer option: Asset allocation is automatic and changes as your needs do.

NOTES: As of Dec 15. To contact: Vanguard, 800-851-4999; T. Rowe Price, 800-638-5660. [1] Includes 5% cash. [2] Includes 30% cash. SOURCE: The fund companies.