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Talk about a steady climb. Even with the stock market getting jittery this fall, the S&P 500 (.SPX) has surged roughly 20% this year. Simply owning an index fund that tracks the market would have been a winning strategy.
Yet even in a vibrant bull market, there are always leaders and laggards. While some funds are trouncing their benchmark this year, overall 56% of stock funds have lagged their index through Sept. 30, according to data from Morningstar. Over the past five years, 72% of domestic stock funds have trailed their benchmark, according to a recent report from S&P Dow Jones Indices.
One reason so many funds fall behind? Many are "index huggers," funds that hold mostly the same stocks as their benchmark index in roughly the same proportions. By tracking the index so closely, their chances of beating become small, especially if they charge high fees.
Still, a small percentage of funds have outperformed over long periods. These funds don't beat their benchmark every year. But over the last five years or more, they've managed to come out on top, indicating they're doing something right to stay ahead.
What sets them apart? Experienced managers, a disciplined investment process and reasonable fees all help. And studies have found that many top-performing funds have a high "active share" — meaning a large percentage of their stock picks deviate from their benchmark.
How you invest plays a role as well. Studies have found that, on average, investors' returns trail the returns reported by the fund industry because of poor timing decisions: buying a fund after it's had a big run or selling just before a rebound.
Investing a steady sum on a regular basis can help capture more of a good fund's performance. And most advisers recommend patience: Even the best funds go through slumps that may last a few years. More important, some advisers say, is the fund's consistency in up-and-down markets over the long run.
"Winning doesn't necessarily mean picking a fund that performs the best; it's about finding one that provides the most consistent results," says Justin Rush, a financial adviser with Storey & Associates in North Canton, Ohio, who uses actively managed funds for his clients. "It's important not to focus solely on performance, but to factor in other fund characteristics."
What are some compelling funds? To find top performers, we asked Lipper to screen for funds with strong records this year as well as the last three and five years. We also looked for funds with reasonable fees, long-term managers and truly active stock pickers, among other indicators of potential success.
Below are five domestic stock funds to consider, based on our research and interviews with money managers. As always, a fund's track record is only one thing to consider and may have no bearing on its future returns. You should consult an adviser or do your own research before investing.
Launched in 1965, Dodge & Cox Stock Fund (DODGX) is a classic value fund. Run by an investment committee based in San Francisco, the $50 billion fund looks for stocks that are temporarily out-of-favor, aiming to hold them for several years.
During the financial crisis, the fund built positions in large banks, which have rallied sharply since then. Financials are now its largest position at around 22% of assets. The fund is also emphasizing technology and health-care companies such as Microsoft (MSFT), Hewlett-Packard (HPQ), and European drug makers Sanofi (SNY) and Novartis (NVS).
The downside: Despite a strong long-term record, this fund "is not a conservative investment," notes Morningstar analyst Laura Lallos. The managers often take contrarian positions that may take years to pay off, hurting the fund's performance temporarily.
The fund plunged 43.3% in 2008 and slid 4.1% in 2011, trailing the market by around six percentage points, before rebounding sharply in 2012. It costs $75 to buy the shares on the Fidelity platform.
Some stocks fare best when the economy is improving; others have more stable and predictable growth. Matthew Fruhan holds both in Fidelity Large Cap Stock Fund (FLCSX), which he's run since 2005.
Venturing across sectors, he aims to buy stocks tied to the economy's performance when their profit margins seem to have hit bottom; he targets "secular" stocks when the market appears to be discounting their growth due to short-term issues that he figures will be overcome.
The result is a wide-ranging portfolio of around 200 stocks. Top holdings include industry giants JP Morgan Chase (JPM), Apple (AAPL) and General Electric (GE). And Fruhan layers in smaller stocks that may provide some extra punch. A top performer this year was Radian Group (RDN), a mortgage insurer that isn't in the S&P 500. Fruhan bought the stock for its exposure to the recovering housing market, and the shares soared as the business rebounded.
Recently, Fruhan has gravitated to stocks that can benefit from rising interest rates, such as banks and payroll processors. He also likes stocks with potential for dividend increases, which he thinks will see higher demand as rates rise.
"Even though the market is making all-time highs, big parts of it are still attractively priced," he says.
The downside: Patience is critical with this fund. It lost 47.5% in 2008 and surged 50.5% in 2009, almost double the market's gain. Over the last five years, it ranks in the top 3% of large-cap stock funds, according to Morningstar.
Investing in small and mid-size stocks, FMI Focus Fund (FMIOX) avoids the big-name companies. Top holdings in the Milwaukee-based fund include aerospace composites maker Hexcel (HXL), health-care technology firm MedAssets (MDAS) and advertising firm MDC Partners (MDCA) — none of which are well-known outside their industries.
"We like to buy good, growing businesses but only at opportunistic prices," says lead manager Richard Lane. Indeed, a stock needs five supporting "pillars" to be considered by the managers, including a strong business, defendable market niche and a share price below the company's private-market value.
One stock Lane likes now: Black Diamond (BDE). The Utah-based company makes rock-climbing and backcountry gear, and is launching a line of apparel that could help double its sales, says Lane, a rock climber himself who discovered the stock on his own.
The downside: The fund's returns fluctuate quite a bit. Yet over Lane's 17-year tenure, the fund's 13.3% annualized return has beaten every other fund in the small-blend category, according to Morningstar.
Based in Pasadena, Calif., the managers of Primecap Odyssey Stock Fund (POSKX) look for bargains among large-cap stocks, aiming to buy when the companies have "short-term blemishes," says co-manager Joel Fried.
"Our ideal stock is a value stock that becomes a growth stock," he says. Lately, that has led to an emphasis on global drug makers such as Roche (RHHBY) and Johnson & Johnson (JNJ), along with tech heavyweights like Microsoft and Texas Instruments (TXN).
The fund hasn't always been a top performer. Yet since launching in late 2004, it has returned an average 8.4% a year, beating the S&P 500 by roughly two points annually. Also impressive: It's achieved those returns with below-average volatility, according to Morningstar.
The downside: The fund's "contrarian growth" style doesn't always pay off. Health-care and technology stocks make up nearly half its assets. If those sectors fall out of favor, the fund's performance could lag. It costs $49.95 to buy the shares on the Fidelity platform.
Midsize companies exist in a kind of Goldilocks zone. They're typically not as risky as small stocks, and they tend to have faster growth than large-caps — offering the best "risk-adjusted" returns, according to John Indellicate, co-manager of the Scout Mid Cap Fund (UMBMX)
Based in Kansas City, Mo., the fund holds stocks selected for their growth or value characteristics. Top holdings include rapid-growth stocks like Internet travel-search firm TripAdvisor (TRIP), along with value stocks such as insurer Hartford Financial Services (HIG). Both companies are going through transitions that should help boost their share prices, says Indellicate.
The fund is also focusing on companies tied to domestic energy production. It owns positions in natural gas producers Gulfport Energy (GPOR) and Cabot Oil & Gas (COG). And Indellicate sees strong potential in Chart Industries (GTLS), a maker of liquid natural gas (LNG) equipment. Though the stock isn't cheap, it should see rapid growth if demand for LNG keeps rising, he says.
Overall, the fund has generated above-average returns with below-average risk, according to Morningstar. The fund captured 118% of the market's upside over the last five years and 95% of its downside. And it's beaten 97% of other mid-cap funds in that stretch.
The downside: Financial and energy stocks combine for a third of the fund's assets. That could hurt returns if those sectors lag.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.