How do the few managed mutual funds that beat the Standard & Poor's 500 Index every year achieve their stunning returns? It is no easy task: S & P 500 index funds have beaten 70% of all managed funds the last 25 years, and in the last three, the percentage has risen to over 90%!

To try and answer this question, I analyzed the best performing funds to see if their returns were simply the result of randomness or whether they shared certain characteristics. If there were shared characteristics, they could be combined into an ideal fund profile, which could be used to add a measure of predictability as to which funds are most likely to deliver future index-plus returns.

Using Morningstar Principia Plus, I analyzed the top-25 performing diversified US funds in each of the last five years (125 funds in all - during the 1993 - 1997 period). The "top-25" delivered a stunning average annual 40.77% return, compared to 20.25% for the Standard and Poor's 500 Index and 16.17% for the average stock fund.

Four criteria showed significant correlation to top-25 performance:

1. Asset size -The median size ranged from a tiny $7 million (1996) to $85 million (1993). Small funds had a clear advantage: no fund began its top-25 year with morethan $2 billion and twenty-five (20%) started with virtually no assets. Some management companies have been criticized for starting a number of small funds under ideal laboratory conditions and then later offering those with the best performance to the public. However, in this study - with two possible exceptions -all funds analyzed were available to the public.

As Vanguard Funds' Chairman John Bogle elegantly sums up the size-versus-performance problem, "Size can kill," so this finding was not surprising. There are legions of formerly above-average funds that became bloated by too much money and dropped back to the average/ below-average pack. One recent Morningstar study showed that with small-cap funds, asset growth beyond as little as $150 million can begin to hamper performance. Clearly, small is good.

2. Fund age - Eighty two funds (66%) were less-than three (calendar) years old and 61 (49%) were one year old or less. Although it flies in the face of conventional wisdom (buy funds with long-term track records), the outperformance of funds in their earliest years, or what Forbes has called the "incubator effect," is significant. In addition to Forbes, the superior performance of new funds has been reported by Kiplinger's, Value Line Mutual Fund Advisor, Lipper Analytical Services, No Load Analyst and Fidelity Insight.

Why? Obviously, new or young funds have no "size problem," and own few, if any, past mistakes. The portfolio manager can focus on decisions about buying, instead of both buying and selling. In addition - particularly with small-cap funds - he or she can be more selective.

3. Manager category - Ninety six funds (77%) were managed by independent managers. The remainder were managed by insurance companies, banks and brokerage firms - brokers' share was only 5%. The superior performance of independent managers is probably due to their freedom to focus on one business managing money. An organization that is - and always has been - focused on a single mission instead of several is likely to be more effective and, importantly, it is freer from conflicts of interest.

4. Investment sector - Eighty five (70%) of the 125 were small-cap funds. This showing was particularly notable - and possibly surprising - because small-cap stocks significantly trailed both large and mid-cap stocks during the period. One might fantasize how much higher the returns might be during a period when small-cap stocks are in favor.

If, during the five years, one had attempted to forecast which funds would become top-25 performers, traditional selection criteria would not have been useful - in fact it would have been counterproductive. Since Morningstar requires a minimum of three years' performance before assigning a rating, the absence of the most widely used selection tool on the planet would have prevented investing in two-thirds of the top-25. Similarly, a low expense ratio, another widely used criterion, would have blocked investment because new funds commonly have high expenses relative to the industry.

The study also revealed the weaknesses of mechanically constructed ratings that ignore the manager category. The fact that 77% of the top-25 funds were run by independent managers is obviously more than mere coincidence. Also, mechanical ratings miss important considerations like the loss of an above-average manager or that swollen assets make future outperformance very unlikely. Mechanical ratings are unable to adjust for a fund's happening to be heavily weighted in the right (or wrong) sector as opposed to a consistent stock-picking ability of a manager. When Morningstar cautions investors against using their ratings as their only fund selection criteria - believe them.

Analysis Conclusion: In order to significantly increase returns, investors must abandon some tradtional principles and strategies in favor of those where the probabilities of above-average performance are more in their favor. Funds selected that share the combined characteristics of past top-25 performers accomplishes that goal. On a random basis, the odds of selecting a top-25 fund are only about one-in-300. While funds with top-25 profiles should increase future returns, they are not, of course, guaranteed to deliver top-25 returns.

Matching candidates to the "top-25" profile is the initial fund-screening step. The next is to examine the surviving qualifiers using more traditional criteria for final selection. The analysis includes the following:

The manager must have an identifiable, above-average track record, not just time-ingrade, managing a similar fund - even though the fund will have no meaningful record.

Does the manager have a significant stake of his own money in the fund? If he is eating his own cooking, it's an important plus for obvious reasons. It's also a plus when the portfolio manager has significant ownership in the fund's management company; it provides staying power. Since an above-average manager is such a rare commodity, odds are high that if he is only a hired gun, he is likely to be lured away to a competitor or start his own company. Does management play musical chairs with its fund managers? Although the NewFund Focus timing discipline (see below) is more short-term than the buy-and-hold approach, confidence that the portfolio manager won't be moved is desirable.

Is management focused on relatively few funds or do they try to be all things to all people? Fewer funds focused on a core investment style such as value or GARP (growth at a reasonable price) is preferable.

Does management have a history of successful fund launchings? If they haven't delivered when the odds of superior performance were most favorable in the past, why bet on their doing so in the future?

Most investors fail in their attempts to increase returns by timing their buys and sells. The problem is that although our head tells us to "buy low, sell high," our stomachs want to do the opposite. It's human nature to want "good" (up) stocks and funds and to avoid "bad" (down) ones. The dollar inflows and outflows of stock and bond funds document the fact that the stomach usually wins and as a result, most folks get the buy-sell sequence backwards. An example: After the severe drubbing of bond funds in 1994, bond fund investors went on strike. Positive inflows didn't resume for almost two years - only after prices exceeded previous highs. This problem is not limited to funds - a study of 10,000 active stock traders by University of California, Davis professor, Terrance Odean, found that traders trailed the market by 7 percentage points.

Numerous studies have shown that the average investor's returns are less than the very funds they invest in. While this would seem to be mathematically impossible, investors accomplish it easily because they chase performance; most invest after funds soar (sporting high mathematically constructed ratings) and sell after they drop (with low ratings).

To explain the math, take for example a fund whose price increases from $12 in January to $18 in September. Attracted by the sharp price rise and favorable publicity, many new shareholders invest in September near the $18 price. Then the price drops and on December 31 it is $15. Relatively few investors benefited from the 12 month price rise ($12 to $15) while many suffered the three month drop ($18 to $15). At year-end, although the fund reported a 25% return ($12 to $15 ), the average investor in the fund had smaller returns than the fund itself- in fact, many had losses.

If this seems far-fetched, despite the "long terms" mantra of investors and the industry, realize that the average investor's holding period is only three years. Subtracting truly long term investors, those remaining trade at a furious pace. You don't read much about this problem because it is in nobody's interest within the industry to publicize it. Recently, however, academicians, consultants and the financial press have reported studies, all with the same dismal conclusion: market timing by "investors" is costing them billions in lost profits and losses.

In collaboration with Morningstar, Tacoma consultants, Frank Russell Company, did a study of 3 5 funds over 13 quarters ending September 3 0, 1997. Compared with those who remained invested, traders investing in volatile funds reduced their average annual returns by almost 12%! A sample is T. Rowe Price Mid-Cap Growth Fund where traders' returns trailed investors' returns by an average of 2.99% per quarter. In a 1996 study, Money reported that that while Dreyfus Aggressive Growth Fund's return was 20.7%, their average investor lost 34.9%; similarly, traders in Van Wagoner Emerging Growth converted the fund's 26.9% profit into a 20% loss.

The lesson is obvious - you can't afford to invest like the average investor. The "top-25" analysis suggests that investing in funds as close to inception as possible, and holding for approximately three years or less is a far better strategy. It neatly takes care of the timing problem that plagues most investors. As a fund with above-average performance approaches the end of its third year, the size-versus-performance problem will probably be looming. If it is awarded the coveted four or five stars by Morningstar, the problem will become acute. The fund will finally be "proven," but it will also probably be bloated and as the crowd lines up to dance with the elephant, you'll be looking for a new dance partner.

Based on the criteria described, my recommendations of funds include an explanation of why I feel the odds favor superior performance.

The typical projected holding period will be three years or less. If a recommended fund closes to cap asset size, it might be a "hold" indefinitely. A fund that fails to perform well compared to its category will be awarded a "sell" and will no longer be monitored.

If a fund performs well, the rating will typically be changed to "hold" sometime in its second year, or earlier if assets swell to a level where the odds of above-average returns diminish. This level will be approximately $150 - $250 million for small-cap funds and $400 - $500 million for mid-cap funds. As recommended funds approach their third anniversary, their rating will probably be changed to sell.

NewFund Focus is not designed to be an all-inclusive model for your total portfolio. Your portfolio's foundation should be constructed with traditional asset allocation and risk management, consistent with your personal circumstances and risk tolerance. As my coauthor Jack Pierce and I said in our book, Winning with Index Mutual Funds - How to Beat Wall Street at its own Game, * "Asset allocation ... dwarfs all other investment considerations." Rather, the primary objective is to increase returns in those sectors where the odds above-average returns are highest -managed small and mid-cap funds. Since small-cap-funds will dominate the recommended list, they may be riskier than their large-cap brethren and suffer more in a stock market decline

With a very few exceptions, large-cap managed funds are not be recommended because the odds of index-plus returns are so low and because those few that accomplish it do so by slim margins. However, large-cap index funds (including structured and enhanced index funds) will be recommended, monitored and reported on regularly.

Other than the typical three-year buy - hold - sell discipline as described, there is no attempt at market timing. Managed small and mid-cap funds are best in tax-deferred accounts such as IRAs and 401(k)s since the typical period is three years or less. Index funds tracking large-cap indexes successfully will be held indefinitely and are better suited for taxable accounts.

I will be happy to answer subscribers' questions and discuss their personal situation via e-mail: jerry@tweddell.com. If I am traveling, replies could take as long as two weeks.

Despite Wall Street's claims that they know best how to invest your money, history shows that investing "the old fashioned way" usually leads to mediocre, sub-index performance. For decades, most investors have been on the costly Wall Street treadmill and the treadmill keeps winning - as index funds have proven.

A better approach is to use NewFund Focus' investment strategy: In the largecap sector where the probabilities of significantly beating the market are dismal, invest in index funds. Where index-plus returns are achievable - in mid and small-cap funds harness the laws of probability and make them work for you, using a probability-driven fund selection and timing discipline. Combining both strategies gives you the best of both worlds.

Jerry Tweddell