Recent winning returns alone shouldn't earn a fund a spot in your portfolio. By James K. Glassman, Contributing Columnist October 18, 2012 Stock mutual funds have been defying the laws of chance lately. In the second quarter of 2012, the average U.S. general stock fund lost 4.6%. Standard & Poor’s 500-stock index lost just 2.8%. For the year that ended July 31, the average U.S. fund returned 2.1%, while the S&P 500 gained 9.1%. Fund managers would have gotten better stock- picking results by throwing darts at a newspaper stock table. Over five years, the picture is a bit better but still uninspiring. The average U.S. stock fund returned 0.6%; the S&P gained 1.1%. For this we pay fund managers big bucks?SEE ALSO: Our Favorite No-Load Mutual Funds Sponsored Content But not all funds have been mediocre. Let’s look at those that have performed well lately and see what lessons they hold for investors, with the understanding that just because a fund has produced big returns doesn’t necessarily mean it’s worth owning. The Perfectionist There’s a lot to like about Oakmark Fund (symbol OAKMX). Over the past five years, it has beaten the S&P 500 by an average of 2.4 percentage points per year and has ranked in the top 4% among funds that invest in large companies with a blend of growth and value attributes, according to Morningstar (results are through July 31). The fund’s risk, measured by its volatility, is just a tiny bit more than the overall stock market’s. Annual expenses are a reasonable 1.04%. Its portfolio of 54 stocks is well diversified, with none representing more than 2.7% of assets. And portfolio turnover, at 18% a year, is low. Advertisement Managers Kevin Grant and Bill Nygren own a lot of stocks that fall into the contrarian camp. Among them are Capital One Financial, which trades at just 9 times estimated year-ahead profits, and Time Warner, which has a price-earnings ratio of 12. They also own some classy manufacturers, such as 3M, with a dividend yield of 2.6% (at a time when ten-year Treasury bonds pay just 1.5%), and Illinois Tool Works, with a yield of 2.7%. The Timer The number-two U.S. stock fund over the past five years is Reynolds Blue Chip Growth (RBCGX), behind only the secretive Oceanstone Fund (see The Mystery of Oceanstone). Reynolds gained 12.3% annualized, beating both the S&P 500 and the typical large-company growth fund by an average of 11 points per year. Stock picking alone doesn’t account for this amazing performance. Frederick Reynolds, the fund’s manager since 1988, started selling stocks in the fall of 2007, and by the end of the year his portfolio was 93% in cash. “Basically, it was a feeling that a lot of stocks were highly priced, and funny things were going on, such as in the mortgage market,” he said later. As a result of this market-timing coup, his fund lost only 5.1% in 2008, the year of the S&P 500’s disastrous 37% plunge. Reynolds piled back into the stock market in 2009 and has done fairly well, though not spectacularly, ever since. Advertisement Today, Reynolds has a broadly diversified portfolio, with 958 stocks and no cash. Over the past year, his fund trailed the S&P by 10.7 points. The fund charges a hefty 1.55% in annual expenses, and unless you think Reynolds is on the verge of another brilliant call, you should stay away. Investors should own stock funds for the stocks, not for the market timing, which is a game neither you nor your fund manager can win in the long term. The Concentrator A fund that has a lot in common with Reynolds is Matthew 25 (MXXVX). Both are small, no-load funds (less than $200 million in assets) run by their founders that charge above-average fees and have achieved above-average results. And both funds worry me. Unlike Frederick Reynolds, Mark Mulholland, Matthew’s manager, does not owe his success to a single intuitive decision. Over the past five years, his fund outpaced the S&P by an average of five points per year; it beat the S&P by the same margin over the past 15 years (the fund launched in 1995). Matthew 25, named for a New Testament parable about investing, currently owns just 22 stocks and one convertible bond. Apple, which Mulholland began buying four years ago, is the top holding, at a disconcerting 17.7% of assets. Most other holdings are in the 4%-to-5% range. In general, a concentrated portfolio is riskier than a more diversified one. Over the past five years, according to Morningstar, Matthew 25 has been about one-fifth more volatile than the S&P 500—which, of course, epitomizes diversification, with 500 stocks. If Apple were to fall 20% and every other stock in the market stayed still, the S&P would drop by about 1% but the fund would lose about 3.5%. Advertisement It’s hard to argue with Mulholland’s record, and I admire the quality and breadth of his holdings. Among them: Cabela’s, a sporting retailer; Goldman Sachs; Google; Caterpillar; and Brandywine Realty Trust, a real estate investment trust. I don’t mind a portfolio with 35 or 40 stocks, but fewer than 25 is too few for comfort. Although I endorse Matthew, I urge you to balance it with other stock funds. The Namesake Some of the best-performing mutual funds carry the name of the founder on the door: Marsico, Jensen, Reynolds, Hennessy, Huber, Royce and more. In this pantheon of eponymy, Donald Yacktman stands out. His Yacktman Focused Fund (YAFFX) ranked sixth among all diversified U.S. stock funds over the past five years. And over the past decade, in good markets and bad, the fund beat the S&P 500 by an average of 5.4 points per year. An investment in the fund at its 1997 launch has more than quadrupled since. Yacktman, his son Stephen and Jason Subotky also run the slightly more diversified Yacktman Fund (YACKX), which was the eighth-best performer over the past five years. (For more on the Yacktman funds, see Best Funds for Blue-Chip Stocks.) Although Don Yacktman is partial to defensive consumer stocks, Yacktman Focused is well rounded. It owns a lot of health care and technology stocks, plus a smattering of energy, communications and financial shares. Its three largest holdings, by far, are Procter & Gamble, yielding 3.5%; PepsiCo, yielding 3.0%; and Rupert Murdoch’s beleaguered but highly profitable News Corp., with a P/E of 11. Together, the three names represent 32% of Focused’s assets, but the fund is diversified enough for my taste, with 38 stocks and a level of volatility in recent years that’s just a smidgeon greater than the S&P’s. And the fund’s turnover rate is a microscopic 2%, implying that Yacktman holds stocks for 50 years, on average. Small But Beautiful Another fund named for its founder—in this case, Kenneth Cutler—Cutler Equity (CALEX) is a fund you’ve probably never heard of. It has a mere $51 million in assets. The fund, run out of Jacksonville, Ore., topped the S&P index by an average of 2.1 points per year over the past five years and by 0.5 point per year over the past 15. But its true attraction is below-average risk. Its portfolio of 35 mega-capitalization stocks is headed by IBM and American Express, both selling at 13 times estimated earnings. Advertisement Big But Beautiful No list of winners would be complete without mention of Fidelity Contrafund (FCNTX) , my all-time favorite stock fund. Will Danoff, who has run Contra for the past 22 years, has to guide his ocean liner with little nudges. He can’t accelerate or come to a screeching stop the way the skipper of a small boat, such as Cutler Equity, can. Yet Contra has thrived. It topped the S&P by an average of 2.1 points a year for the past five years and finished in the top 8% of the large-company-growth-fund category over the past decade. And it did so with below-average risk. Danoff just happens to be an excellent stock picker. Plus, annual fees are only 0.81%. The $82 billion fund, a member of the Kiplinger 25, owns about $8 billion worth of Apple and $4 billion worth of Google. All of these funds are managed by living, breathing human beings. Choosing such funds over lower-cost mutual funds and exchange-traded funds that simply seek to match an index may be, like second marriages, the triumph of hope over experience. But some funds are just good. Trying to find them is worth the effort. James K. Glassman is executive director of the George W. Bush Institute. His new book on economics is The 4% Solution. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!