Money 70: The best mutual funds you can own

NEW YORK (Money Magazine) -- Sometimes you feel the biggest regrets when everything is going right. Stock funds have delivered solid returns for four years in a row, the Dow Jones industrial average has broken new records, and your portfolio has been growing nicely.

It's all good, but...darn, if only you'd had more money last year in emerging markets (up 29 percent on average) or real estate funds (up 33 percent). Now your 12 percent or 15 percent return looks, well, kind of lousy.

Get over it.

Obsessing over performance numbers is exactly the wrong way to build an investment portfolio. You'll feel a lot better - and become a better investor - if you accept this inconvenient truth: Trying to predict which funds will deliver the best short-term returns is futile.

Funds that zoom to the top of the charts often get there because either their area of the market is hot (see above) or their managers are taking huge risks. History suggests that the place to look for them next year is the bottom of the rankings.

That's why Money Magazine's list of recommended funds is not about aiming for the highest short-term returns. Our lineup is designed to let you build a well-balanced portfolio that will help you reach your most important financial goals, like putting your kids through college, starting a business or achieving a comfortable retirement.

To identify funds that deserve a spot on our list, we focus on criteria that have real predictive value: low expenses, a strong record for putting share-holder interests first and a consistent investment strategy.

A fund that meets our standards typically ends up delivering above-average returns - two-thirds of the actively-managed funds on our list posted returns that ranked in the top half of their category last year, and nearly 90 percent did so over five years.

Our roster includes a range of actively managed stock, bond and specialty portfolios, as well as a full complement of low-cost index and exchange-traded funds.

Or you can put your investments on cruise control with one of our target-date retirement portfolios, which automatically shift their asset mix to become more conservative as you get older. This year we added six funds (and dropped one) to what had been the Money 65.

That allowed us to include several funds that can provide you with more diversification - including investments in real estate, emerging markets stocks and commodities.

It also let us include a few funds run by talented managers who don't fit into standard fund categories because they invest in companies of all sizes. (To see how the Money 70 can be used to build portfolios for a variety of financial goals, check out "The Perfect Money Makeover.")

Money Magazine has long preached that the core of most people's portfolios should be in index funds. Their low costs and ease of use make them hard to beat. To select index funds for the Money 70, we sought portfolios with ultralow expenses (so your return is as close as possible to the return of the market segment the fund tracks) and focused on companies with strong indexing track records.

That sounds like a job description for Vanguard, and that fund group dominates our index roster. Still, Fidelity's index funds are highly competitive, and two of its entries make the grade.

We took the same approach with our ETFs - here Barclays iShares rules our list, along with Vanguard.

But we also know that many investors want a shot at beating the market or prefer to invest more conservatively than index funds alone permit. That's why the 70 includes actively managed funds.

In picking them, we ruled out those that hold less than $100 million in assets, since their records are often a poor indication of how they'll operate as they grow. Our funds must be managed by the same person or team for at least three years, although we may include a new fund run by managers with established records; and managers must follow a well-defined investing strategy.

We winnowed out funds with expenses that are above average for their category, as well as those that trade excessively, which racks up performance-sapping costs.

When it comes to performance, we looked for funds that rank in the top half of their category over five years. But we'll keep lagging funds that are already on our list if the underperformance is simply attributable to the manager's stock-picking style being out of favor, not to poor investing or other problems.

That's the case with American Funds American Mutual, FAM Value, Fidelity Dividend Growth, FPA New Income and Madison Mosaic Investors, which now have mediocre five-year records.

You don't want to dump a fund just as the manager's style comes back in vogue, and we believe these pros can do well again. But we'll keep an eye on them.

Finally, in order to make sure that shareholder interests come first, we eliminated funds that received a stewardship grade of less than B from Morningstar. The grades are based on a fund's status with regulators; the quality of its board of directors; expenses; manager incentives; and corporate culture. If Morningstar doesn't grade a fund, we used our judgment.

A so-so stewardship grade accounts for one of the changes on our list: We dropped Meridian Value. Run by Richard Aster and James England, the fund got a C from Morningstar due to concerns that the managers' compensation plan encourages asset building at the expense of shareholders and that England has little of his own money in the fund. Aster says shareholders aren't being hurt, and while we don't think you need to sell the fund, it would be better if he and England made changes.

We continue to recommend Meridian Growth, a midcap growth fund led by Aster, which gets a B grade from Morningstar.

Now for the additions. Our new "multicap" category highlights managers who go wherever they see bargains, whether among small- or large-company stocks.

True, a multicap fund can complicate your asset allocation, but stashing 5 percent of your stock portfolio in one can give you a shot at higher returns without your taking on too much risk.

We reassigned the Muhlenkamp fund, formerly a midcap entry, since the go-anywhere category is a better fit for manager Ron Muhlenkamp's strategy.

We're adding Bridgeway Aggressive Investors 2, run by John Montgomery, who uses computer models to pick stocks in all market-capitalization ranges. The Bridgeway shop runs 10 other funds, all with rock-bottom fees and good performance records.

Another newcomer is Weitz Hickory, run by Wally Weitz, a well-known manager who buys out-of-favor stocks with the goal of holding them until the market recognizes their value.

Two former entries on our list are returning. One is FPA Perennial, a one-time small-cap fund that we dropped when the managers began buying more midcap stocks. It's now in our midcap category.

The other returning fund is Third Avenue Real Estate Value, which recently reopened to new investors. Unlike most real estate funds, which invest in real estate investment trusts, Third Avenue focuses on operating companies as well as foreign stocks.

Since REITs have been on a tear lately, Third Avenue's returns seem underwhelming. But over the long run, the fund's strategy offers potential for bigger gains than REITs and provides greater diversification.

We've made two other moves on the diversification front.

We added T. Rowe Price Emerging Markets, which includes stock picks from three T. Rowe regional foreign funds. The combination has proved a winning formula, since the fund has more than kept up with the sizzling returns in this category. After such a great run, however, performance is bound to cool, and emerging markets are prone to stomach-turning drops. If you're just starting to invest now, put in a little each month and stay with it.

Finally, we added a diversifier to our index lineup: iPath Dow Jones-AIG Commodity Index Total Return. This is technically an exchange-traded note, or debt security. That structure is designed to minimize taxes, but for all practical purposes, this offering is an ETF: You buy and sell it through your broker just like a stock.

Unlike other commodity ETFs, which invest the bulk of their assets in energy, the iPath ETN also holds substantial stakes in metals and agricultural products - again providing broader diversification. Holding a 3 percent to 10 percent stake in commodities can reduce the risk in your portfolio, since those assets do not move in sync with the U.S. stock market.

Will the funds in the Money 70 perform better than the majority of their peers next year or the year after that? We don't know, and anyone who claims to is fibbing.

What we do know is that your returns won't be eroded by high fees, and that the managers won't betray your trust and will hew to their investing strategy. That, in turn, will make it easier for you to build toward your goals.

So no more regrets that you didn't happen to own last year's hottest funds. Instead, use the Money 70 to construct a portfolio to last, and in the long run you'll do just fine.

The Money 70: Best funds you can own

Perfect Money Makeovers:

Richard Rivera and Cynthia Centeno: Married, with a windfall

Brian and Kim O'Donnell: Starting out in hock

Marilyn Cazayoux: Playing catch-up

The Van Almelos: Building a business

Ramon and Anne Evans: Making their money last