Best performing mutual funds of 2013

Use these recommended mutual and exchange-traded funds to construct a portfolio that’s built to last.
When Money magazine introduced the MONEY 70 list in 2007, the investing landscape sure was different. Exchange-traded funds were just coming onto the scene, and the merits of the strategy guiding them and index mutual funds were still the subject of great debate.

Fast-forward to today. ETFs, which are baskets of securities that you can buy and sell throughout the day, are now part of the mainstream. And indexing has won the argument. Only one in four actively managed U.S. stock funds has beaten this approach over the past five years, raising doubts about whether you need to sift through scores of funds to create a diversified and effective portfolio. That is in part why we overhauled the list.

Welcome to the new MONEY 50. In addition to being more concise, the list is organized differently. Rather than grouping funds based on the types of stocks or bonds they own, the new MONEY 50 categorizes funds based on how you might use them.

For instance, do you plan to use them as building blocks for the core part of your portfolio? Or will you hold them in small doses, to customize your strategy?

Despite those changes, the purpose of the list remains the same: to help you build a balanced portfolio that will get you to your most important financial goals, such as putting your kids through college or achieving a comfortable retirement.

We reconfigured the list into three broad categories, based on how elaborate you want your portfolio to be.

Building-block funds. This category, which contains 14 low-cost index funds and ETFs, is designed to help you assemble your core portfolio, which you’re likely to hang on to for years and which represents the bulk of your assets.

Why just index funds? Low-cost indexes offer the purest and cheapest exposure to broad swaths of the markets, which you’ll want for your core. Studies show that most active managers fall short of their benchmarks because of the higher fees, trading costs, and timing errors associated with frequent trading.

You should be able to construct a well-diversified portfolio with as few as three or four of the broad-market index funds found in the building-block section.

Custom funds. Even a well-diversified core portfolio may not be enough to meet all of your needs. You may prefer to keep a small stake in actively managed funds, for instance, in hopes of earning a bit more return. Or perhaps you want to further diversify your portfolio by using alternative assets, such as real estate or commodities.

This section includes 32 choices that allow you to craft a more specialized mix. If you are closing in on retirement and are seeking to boost income through dividend-paying stocks, you might choose SPDR S&P Dividend ETF.

Younger, more aggressive investors might opt for a fund that holds bargain-priced small-cap stocks, such as Vanguard Small-Cap Value ETF. Because of the added risks, limit your stake in these specialized funds. The bulk of your portfolio belongs in your core.

One-decision funds. Prefer to leave the work to the pros? Then avoid the first two categories altogether and opt for the third: all-in-one funds, which include two target-date retirement series and two balanced funds.

All these portfolios give you instant and sufficient diversification. But with target-date funds, the asset mix becomes more conservative as you approach retirement. Balanced funds, by contrast, maintain a constant allocation, typically around 60% to 65% stocks and 35% to 40% bonds. If you’re unlikely or unwilling to monitor and tweak your portfolio over time, your best bet is a target-date fund that suits your age.

Making of the MONEY 50

MONEY ignores last year’s hottest funds and instead looks for solid long-term performers with these important traits:

Low fees: Below-average expense ratios are a good predictor of better-than-average performance.
Average expenses for actively managed MONEY 50 funds: 0.91%
Average stock fund 1.41%

Long tenure: Good returns don’t mean much if the manager responsible for them is no longer around.
Average tenure for a MONEY 50 manager: 11.5 years
For fund industry 5.7 years

Strong stewardship: You want fund managers who put the interests of shareholders ahead of their own. We use Morningstar stewardship grades for that.
Percent of actively managed MONEY 50 funds graded A or B: 62%
Percent of all actively managed stock funds graded that high: 16%

NOTE: For funds that do not receive any stewardship grade from Morningstar. MONEY relies on its own assessment. SOURCE: Morningstar

Agencies