Top Mutual Funds: Constructing a Top Mutual Fund Portfolio

Chasing top mutual funds with little insight on performance drivers usually gets you nowhere. Want to learn how you can use mutual fund data to gainfully increase returns and reduce risk? Read on ...

The top mutual fund based on three-year returns is US Global Investors Global Resources Fund.

The top mutual fund based on ten-year returns is Wasatch Micro Cap Fund.

The top performing mutual fund usually varies from one time period to another as investment styles and sectors come in and go out of favor. While screening tools readily provide such performance data and make the task of identifying top mutual funds relatively easy, there is more to constructing a top mutual fund portfolio than screening for top mutual funds.

This article describes methods of constructing top mutual fund portfolios. Before getting started on constructing top mutual fund portfolios, it helps to know how equity mutual funds are classified and how performance of an equity mutual fund is impacted by market conditions.

Mutual Fund Classification by Market Capitalization & Style

Equity mutual funds are commonly classified based on the market capitalization of the companies in which an equity mutual fund invests its assets, and the investment style of the mutual fund.

Market capitalization is divided into three categories: large, medium, and small. Investment style likewise is divided into three categories: value, growth, and blend.

Combining both types of classifications, equity mutual funds typically fall into one of nine boxes on a 3 x 3 matrix. This classification system works well in analyzing diversified equity mutual funds.

Mutual Fund Classification by Sector & Industry Group

Instead of slicing the equity market by market capitalization or investment characteristics such as value or growth, an alternative way is to break-up the equity market by sectors. The Global Industry Classification System jointly developed by Standard & Poor's and Morgan Stanley Capital International, for example, divides the equity market into ten sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services, and Utilities. Each sector in turn is divided into several industry groups. This classification system is particularly useful for analyzing equity mutual funds that invest their assets in a given sector like technology or industry group like computer hardware.

Top Mutual Funds & Business Cycle

Equity mutual fund prices change in response to prices of stocks held in the mutual fund's portfolio. Generally speaking, stock prices are impacted by business conditions. The business cycle has various phases to it: Recovery, Boom, Slowdown, and Recession. Different parts of the stock market as seen from market capitalization, style, or sector perspectives perform differently in different phases of the business cycle.

(A) Diversified Mutual Funds

Growth style mutual funds, in general, fare well during expansion phases such as recovery and boom, and value style mutual funds during contraction phases such as slowdown and recession. Likewise, from a capitalization perspective, small cap mutual funds tend to perform better during expansion and large cap mutual funds during contraction.

Looking at the most recent boom-bust cycle, Spectra Fund, a large cap-growth mutual fund, was among the top mutual funds during the 1997-1999 boom. The mutual fund gained 141% during the three-year period ending October 31, 1999. However, Spectra fared poorly during the 2000-2002 slowdown; the mutual fund lost 52% during the two-year period ending October 31, 2002.

In complete contrast, Hotchkis & Wiley Small Cap Value Fund, which failed to participate in the 1997-1999 boom, was among the top mutual funds during the 2000-2002 slowdown. Following the 30% loss for the two-year period ending June 30, 2000, Hotchkis gained 88% during the two-year period ending June 30, 2002.

(B) Sector Funds

Like diversified mutual funds, certain sector funds tend to perform better during some phases of the business cycle. Sector funds that invest in economically sensitive sectors such as technology typically tend to perform better during the expansion phases. Sector funds that invest in economically less sensitive sectors like consumer staples typically tend to perform better during the contraction phases. As a result, a sector fund that is among the top mutual funds in one time-period may not perform as well in another time-period.

Among the 41 Fidelity sector funds, Fidelity Select Energy Services was the top mutual fund in 2005 with a 54% gain. However in 2003, Fidelity Select Energy Services gained just 8% to be the worst performer.

Top Mutual Fund Portfolio Rather Than Top Mutual Funds

Can one select the top mutual fund by knowing what stage the business cycle is in? Things unfortunately do not get that easy.

Getting the turning points of the business cycle right is less than a science. Although certain styles and sectors are expected to do better during particular stages of the business cycle, there is no certainty they will do so each time. Additionally, stock prices tend to anticipate and lead the business cycle. The top mutual fund therefore usually varies from one economic cycle to another.

So, rather than chase top mutual funds, the better choice is to build a robust, all-weather top mutual fund portfolio.

Top Mutual Fund Portfolio with Diversified Mutual Funds

One way to construct a top mutual fund portfolio is to use diversified mutual funds that emphasize different types of market capitalizations and investment styles. To simplify portfolio composition, one may construct a top mutual fund portfolio using a large cap-growth mutual fund, a large cap-value mutual fund, a small cap-growth mutual fund, and a small cap-value mutual fund.

In evaluating top mutual funds in each category, focus on the long-term track record and see how the mutual fund has fared in different market environments. Complement this by evaluating mutual funds on non-performance-based metrics such as manager tenure, price volatility or risk, fees, and fiduciary grade. Choose the best mutual fund in each category and build your top mutual fund portfolio with managers of a 'dream team' caliber.

Alternatively, if you want to restrict yourself to only one mutual fund to start with, you may consider a total market index fund which spans all capitalizations and styles.

Top Mutual Fund Portfolio with Sector Funds

Sector funds can also be used to construct a top mutual fund portfolio. This approach offers the advantage of creating customized diversified portfolios by including sectors and industry groups likely to outperform the market indexes and excluding those likely to under-perform.

Reward potential can be enhanced by concentrating in a few sectors or industry groups. Diversification across several sectors and industry groups serves to mitigate risk. By optimizing the balance between concentration and diversification, one can achieve superior nominal and risk-adjusted returns.

The AlphaProfit Core model portfolio exemplifies this approach. Over the 33 month period from September 30, 2003 to June 30, 2006, the AlphaProfit Core model portfolio gained 57% compared to 39% for Dow Jones Wilshire 5000 Total Market Index.

Key Points

1. There are no top mutual funds for all times and climes.
2. Rather than chase top mutual funds, a more prudent choice is to build a robust, all-weather top mutual fund portfolio.
3. Diversified mutual funds as well as sector funds can be used to construct top mutual fund portfolios.

Related Links
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Sam Subramanian
AlphaProfit Investments, LLC
August 23, 2006

Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. He edits the AlphaProfit Sector Investors' Newsletter™. This mutual fund newsletter provides sector insights and research to help investors construct top mutual fund portfolios. The investment newsletter is ranked #1 by Hulbert Financial Digest.

Notes: This report is for information purposes only. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice. This report does not have regard to the specific investment objectives, financial situation, and particular needs of any specific person who may receive this report. The information contained in this report is obtained from various sources believed to be accurate and is provided without warranties of any kind. AlphaProfit Investments, LLC does not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. AlphaProfit Investments, LLC is not responsible for any errors or omissions herein. Opinions expressed herein reflect the opinion of AlphaProfit Investments, LLC and are subject to change without notice. AlphaProfit Investments, LLC disclaims any liability for any direct or incidental loss incurred by applying any of the information in this report. The third-party trademarks or service marks appearing within this report are the property of their respective owners. All other trademarks appearing herein are the property of AlphaProfit Investments, LLC. Owners and employees of AlphaProfit Investments, LLC for their own accounts invest in the Fidelity Mutual Funds included in the AlphaProfit Core and Focus model portfolios. AlphaProfit Investments, LLC neither is associated with nor receives any compensation from Fidelity Investments or other mutual fund companies mentioned in this report. Past performance is neither an indication of nor a guarantee for future results. No part of this document may be reproduced in any manner without written permission of AlphaProfit Investments, LLC. Copyright © 2006 AlphaProfit Investments, LLC. All rights reserved.