Funds that mint money

(Fortune Magazine) -- The best mutual fund managers are an exceptionally dedicated lot. They devote hour upon hour to screening and researching investment ideas, poring over reams of data in the process. They traverse the country - and often the world - to get up close and personal with the companies whose stocks they buy. And they constantly evaluate their own portfolios, looking for ways to minimize risk. All in the service of providing the best returns possible to investors.

But no matter how hard the managers work, there's one variable in the process they cannot control, one factor that can undermine even their best efforts - you.

More from Fortune

Will Mmmhops be a hit? NBA confirms L.A. Clippers sale to ex-Microsoft CEO Steve Ballmer FBI and SEC probe into Carl Icahn and golfer Phil Mickelson

FORTUNE 500 Current Issue Subscribe to Fortune

Investior's guide 10 rules for building wealth Fumbling when it comes to investing? Don't panic. There are easy ways to get your money to work for you. (more) 10 stocks to buy now With oil prices and a housing bust threatening the economy, we discovered ten solid stocks that can still pack a punch. (more) 7 funds that mint money The numbers don't lie. Here are seven great choices that investors can count on for the long term. (more) The next great eurostars Europe's economies may be growing slowly, but its markets are heading for a fourth year of double-digit increases. We found six promising stocks. (more)

Fund Update A look back at last year's picks Last year we recommended seven funds with stellar long-term records - and excellent long-term prospects. So far they have underperformed the market: As of Dec. 5, 2006, the funds together had an average one-year return of 12 percent, vs. 14 percent for the S&P 500. Our choice from last year with the worst record is Calamos Growth, which returned only 3.1 percent for investors. The best performer among last year's picks was the Oppenheimer Global Opportunities fund, which posted a 20.3 percent gain. Our choice from last year with the worst record is Calamos Growth, which returned only 3.1 percent for investors.

Fear. Greed. Panic. Sadly, all the base instincts that sabotage individual investors in their stock picking also apply when it comes to mutual funds. We tend to yank money from our large-cap growth portfolio if the Dow sags for six months or pile into a new tech-sector fund after semiconductor stocks make a run. As a result we often fail to get the full benefit of even our best investment choices.

Research firm Morningstar has calculated that the average diversified equity fund has produced an annual return of 8.46 percent over the past ten years. But the average fund investor got just 7.05 percent a year on his money, or 17 percent less.

To help you overcome those counterproductive tendencies, this year we introduced new criteria in our search for the best funds - dollar-weighted returns, or, as Morningstar calls them, investor returns.

In June, Morningstar began publishing investor returns for all the funds it covers. The more familiar total return figures - the ones you see cited in marketing literature - reflect the changes in the value of a fund's portfolio (including reinvested dividends) over a specific period, say three or five years. These are valuable statistics for gauging relative performance.

But investor-return numbers take into account a fund's inflows and outflows, providing a fuller picture of how investors really fared. Say that fund X has a monster year, with a 100 percent return, and money floods in during December, tripling the fund's size. Then the next year fund X loses 20 percent. Over two years the fund would be up a stellar 60 percent, but the majority of shareholders would have lost money and the fund would have a negative investor return.

A fund's investor return can exceed its total return if more investors bought in on the upswing. This is true for several of our fund choices and often happens when investors are making regular contributions to a fund despite a slight downturn. (For more on investor returns, see global.morningstar.com/investorreturn.)

The dollar-weighted return data can be useful in picking the right funds. Morningstar's analysis of investor-return data shows that investors tend to do worse in volatile, high-risk funds than in cautious, steady ones. That makes sense. Dramatic dips can frighten us into selling prematurely. The dollar-weighted returns of the most volatile high-risk funds as a group were just 62 percent of their total returns over the most recent ten years measured by Morningstar. By comparison, investor returns for the least volatile funds almost matched their total returns.

To harness the power of this analysis, we used Morningstar's data to screen for funds with both total returns and investor returns in the top 20 percent of their categories over ten years. Then we eliminated funds that are closed to new investors as well as those with high minimum-investment requirements or excessive expenses.

In the end we chose one large-cap, one mid-cap, one small-cap and one moderate-allocation name, as well as a pair of international offerings and an emerging-market fund. What do they all have in common? A cautious yet successful approach that inspires patience rather than panic. It's a portfolio designed to help the buy-and-hold investor help himself.

Phil Davidson, co-manager of the American Century Equity Income fund, mentions "downside" so often that you might start to think he needs some Zoloft in his coffee. But Davidson isn't dour - he's merely obsessed with avoiding stocks that are ripe for a tumble.

Davidson and his co-managers are willing to buy solid stocks of all sizes for their $6.2 billion mostly large-cap portfolio, as long as they find that margin of safety. They also mix in some convertible securities for added income and lower volatility. That kind of conservatism makes the portfolio less likely to keep up during torrid bull runs, but it also serves to limit losses, a key to long-term outperformance. The fund's worst loss in any one calendar year was a 5 percent slide in 2002, a year when the average large-value fund sank 18 percent. Over the past ten years, the fund has gained nearly 13 percent a year, with dollar-weighted returns of nearly 12 percent.

Limited risk is one big reason the managers have loaded up on shares of General Electric (Charts). The bluest of blue chips has a AAA balance sheet and carries a 2.8 percent dividend yield. That's why Davidson is only too happy to hold on to GE, his top holding, for the long term. "The probability of success with this investment is so high that I don't care if it goes sideways for another year," says Davidson.

Change is good, or at least it has been for the owners of the Excelsior Mid Cap Value and Restructuring fund. "The market is reasonably efficient," says co-manager Timothy Evnin, "but it is less good at valuing companies that are going through significant adjustments." That creates fertile ground for Evnin and co-manager John McDermott. But the managers won't buy just any company that's restructuring for their relatively small $290 million fund. Instead, they sift through businesses with market capitalizations roughly between $2 billion and $12 billion, looking for turnaround stories with unrecognized growth potential or the promise of high returns on capital. They also consider stocks hurt by competitive or regulatory shifts and those simply battered by swings in investor sentiment.

One of Evnin and McDermott's recent additions is Kennametal (Charts), a Latrobe, Pa., maker of metalworking tools and construction equipment. The company recently raised its dividend and approved a stock-buyback plan. It has also committed to cutting costs significantly over the next couple of years. But the real opportunity, Evnin says, is that Kennametal is restructuring to focus less on traditional metalworking and more on advanced materials, a business with higher margins and better growth potential. "Investors aren't giving them enough credit for a significant restructuring opportunity that we see coming," he says.

Chuck Royce first took the helm of the Pennsylvania Mutual fund in the midst of a brutal bear market in 1972. The fund nose-dived early on, but Royce, the longest tenured of all small-cap managers, has more than made up for it over time. In fact, Pennsylvania Mutual, long the flagship fund of his investment company, has managed an average total return of nearly 16 percent annually over the past 30 years. In the process it has beaten the Russell 2000 small-cap index over the three-, five, ten-, 15-, 20-, and 25-year periods ending Nov. 30, 2006.

While small stocks are considered riskier than large ones, Royce, 67, still applies the lessons of that '70s bear market and as a result, focuses on preventing painful losses even during market downturns. These days, because he believes the economy will grow more slowly over the next couple of years than it has in the past few, Royce says he has been shifting away from microcaps and into larger, higher-quality companies.

Royce's top holdings include asset-management firm AllianceBernstein, welding-equipment maker Lincoln Electric Holdings and teen retailer Claire's Stores (Charts). "We have a three- to five-year horizon, so we can afford to be wrong in the short term," Royce says. "We are buying something because we believe we can compound at a mid-teens or 20 percent rate."

"How much money could we lose?" That's the first question co-managers Jeff Arricale and David Giroux consider when evaluating a stock for the T. Rowe Price Capital Appreciation fund.

And that extra-cautious mindset is exactly why losing money hasn't been much of an issue throughout the fund's history. The portfolio, which is designed for stability with its blend of value stocks, convertible bonds, traditional fixed-income offerings and cash, has racked up positive returns every year for 15 consecutive years. And it has averaged a total return of 12.3 percent a year over ten years.

That record was mostly built under other managers - Arricale and Giroux took over the fund in June. But the pair had worked closely on the portfolio with former manager Stephen Boesel for years, and they insist that the approach will remain the same. Like Chuck Royce, right now they're positioning their portfolio more defensively in preparation for a slowdown in economic growth. That means buying into businesses that are less economically sensitive and offer relatively high dividend yields. It also means building positions in a number of possible takeover candidates and in companies that are restructuring and can therefore achieve double-digit earnings growth without depending on a rapidly expanding economy.

One of those restructuring stories is Tyco International (Charts), the conglomerate that will be breaking itself up into separate electronics, health-care and fire and security businesses. While Tyco currently trades at about 15 times its projected 2007 earnings, the managers note that the three companies' peers typically trade for higher P/E multiples. "When we look at where we think the parts are going to trade over the next three years, it's our most compelling idea in the portfolio," Arricale says.

On a business trip to Tokyo last month, William Kennedy woke up at 4:15 one morning to find 45 voicemail messages waiting for him. While he was sleeping, a bevy of Fidelity analysts had called to provide their take on earnings announcements or report back on visits with corporate management teams. It's an excellent example of the global research he draws on as manager of the $8.7 billion Fidelity International Discovery fund. "That's why I can own 300 names and keep on top of them," says Kennedy, who took over the fund in January 2005.

Lately, Kennedy has been finding the best values among large-cap European names. The 50 largest companies in Europe are trading for around 12.5 times earnings, he notes, compared with a multiple of 15.9 for the S&P 500. At the same time, those European giants carry a dividend yield better than 3 percent, compared with 1.8 percent for the S&P.

An excellent alternative for those seeking a big global fund is Vanguard's International Value. The $7.3 billion portfolio is split among three subadvisors. Kevin Simms and Henry D'Auria, who steer the AllianceBernstein International Value fund, oversee about 45 percent of assets, while Ronald Holt and Aureole Foong of Hansberger Global Advisors now manage 43 percent of the money. Vanguard added Lazard Asset Management to the mix earlier this year. The goal, explains Joe Brennan, Vanguard's head of portfolio review, is to get great performance with less volatility than might be expected with just one manager. As with all Vanguard funds, expenses are astoundingly low - at 0.50 percent they are less than a third of the typical international fund's.

All three subadvisory groups hunt for values outside the U.S. by focusing on individual companies rather than macroeconomic trends. Combined, they manage a portfolio of 230 stocks that includes big stakes in blue chips such as French oil giant Total and British cellular leader Vodafone (Charts).

From Kazakhstan to Korea, lead manager Chris Alderson of the T. Rowe Price Emerging Markets Stock fund is not afraid to go anywhere in search of a promising growth stock. Anywhere, that is, as long as he and his three co-managers are comfortable with the country's economic outlook - something they monitor constantly. Right now, for example, Alderson is particularly bullish on India and Taiwan, but finds Hungary unappealing.

The team's 133-stock portfolio is loaded with big names such as America Movil (Charts) of Mexico, along with some less recognizable companies such as Bharti Televentures of India and Naspers of South Africa, a pay-TV and Internet service provider for most of the African continent. Alderson expects Naspers to grow at 25 percent to 30 percent a year, but the stock, he says, trades for just 13 times his projected earnings for 2007.

Alderson's fund has done particularly well as emerging markets have rallied over the past three years, soaring an average of almost 33 percent annually. Adding to the fund's appeal is a relatively low 1.27 percent expense ratio - "just about the best deal retail investors can get in this category," a Morningstar analyst wrote recently.

Weighted in your favor To identify the best funds, we screened for high total returns as well as investor, or dollar-weighted, returns. Investor returns factor in money flows to better calculate results for an average shareholder. These seven funds stood out.

_________________________________

Fortune Magazine 10 rules for building wealth