Gold and emerging market stock funds held onto their top spots in this year’s ranking of the top mutual funds over the past five years.

Bond funds were also very prevalent among the best-performing categories. Conversely, large-cap domestic funds remained among the worst-performing categories.

The numbers reflect both the importance of diversification and the frustration still felt by many investors. Those who maintained a heavy allocation to U.S.large-cap stock funds since the start of 2006 found themselves more reliant than they would have liked on dividends for a source of total return. Those who owned funds from a variety of categories are now feeling rewarded for withstanding both the downward and upward volatility of the past several years.

What may not be as apparent is the importance of proactive rebalancing, as opposed to reactive selling. For example, though large-cap stock funds lag on a five-year basis, they rank in the top half in terms of 2010 performance. A simple strategy of annual rebalancing would have allowed you to buy low and sell high, the exact opposite of what many panicked investors did during the last bear market.

Thus, though five-year performance does provide useful insight into trends, you should not use it as a timing indicator to determine which categories to go into and which to jump out of. Rather, you should use it as a guide to help identify which funds have consistently outperformed their peers over a long period of time. A fund manager can get lucky from year to year, but it takes skill to beat one’s peers for an extended period of time.

Gold Continues to Glitter

Gold held onto its spot as the mutual fund category with the best five-year performance, led by USAA Precious Metals & Minerals (USAGX) and Tocqueville Gold (TGLDX). The two funds have five-year average returns of 25.6% and 23.8%, respectively. A rally in gold from below $600 to above $1,400 was the key driver behind these impressive returns.

USAGX holds shares of mining companies. Mining companies provide investors leverage in that as long as the price of a metal rises faster than the cost of extracting it, profit margins widen. This is exactly what has happened over the past five years. TGLDX also holds shares of mining companies, but its largest position at the end of 2010 was physical gold itself (5.6% of the portfolio.)

Gold was also the best-performing fund category in 2010. Whether gold funds continue to lead over the next five years depends on how the precious metal fares. Though gold is viewed as a hedge against inflation, if actual inflation turns out to be lower than forecast, both gold and gold mining companies could be adversely affected.

Emerging Markets Aided by Growth

Strong economic growth put three emerging market funds into the overall five-year best-performer’s list. Those funds are Matthews China Investor (MCHFX), Oberweis China Opportunities (OBCHX) and T. Rowe Price Latin America (PRLAX).

Both MCHFX and PRLAX join the two aforementioned gold funds with appearances in our overall top-five list for the second consecutive year. Unlike the gold funds, however, none of these emerging market funds were among 2010’s top-performing funds. Attempts by Chinato prevent its fast pace of economic growth from sending inflation spiraling out of control slowed the wind behind Chinese stocks’ backs. PRLAX had approximately two-thirds of its portfolio invested in Brazilas of year-end 2010. Though Brazilshould benefit from higher commodity prices, it remains to be seen if the new president, Dilma Rouseff, will be able to continue the economic success realized by her predecessor, Luiz Inacio Lula da Silva.

Bond Funds Among Leaders

Bond-related categories claimed three of the top six posts in the five-year rankings of category averages. Emerging international bond was the third-best category with an average five-year return of 7.6%, followed by corporate high-yield bond and convertible bond in fifth and sixth place, respectively.

Note that all three categories invest in bonds with comparatively greater risk. Emerging markets have historically had a higher risk of default. High-yield bonds are issued by companies with weaker credit ratings. Convertible bonds are often issued by companies as a sweetener to get a lower interest rate than a traditional bond offering from the same company would bring. This is why the total risk index scores for all three top-ranking bond-related categories are higher than those of many other bond categories.

Top performers in these bond categories include Fidelity New Markets Income (FNMIX), Fidelity Capital & Income (FAGIX), and Osterweis Strategic  Income (OSTIX). When looking at these mutual funds, keep in mind that interest rates and bond prices are inversely related. This said, bond funds will continue to play an important role as part of a diversified mutual fund portfolio.

A Winning Portfolio

Maintaining an exposure to stocks and riding out the volatility of the past four years created wealth. Simply matching the average performance for the top 10 categories would have resulted in an average annualized five-year return of 7.8%.

It should be noted that this figure was significantly influenced by the ascent of precious metal prices. Excluding gold and instead investing only in the next nine best categories would drag the average return down to 6.8%. Not a bad return, but significantly lower than the return a 10% allocation to gold funds would have generated.

So what would this portfolio have looked liked? In addition to gold, mutual funds within the emerging stock, energy/resources sector, miscellaneous sector, regional/country stock and technology sector categories would have been included in the equity-focused side of the portfolio. On the fixed-income side, the portfolio would have held mutual funds from the emerging international bond, corporate high-yield bond, convertible bond and general international bond categories.

Commodity and international market exposure is prevalent in this portfolio. Therefore, while the five-year performance looks good, it comes with a higher level of risk. Investors may have been rewarded for taking on this extra risk, but keep in mind that past performance is no guarantee of future returns.

Table 1 ranks each mutual fund category by five-year category average. The table also shows the total risk index and bull and bear market returns. Higher risk index scores mean the category has experienced a comparatively greater amount of volatility. Bull market returns are calculated using the period March 1, 2009, through December 31, 2010. Bear market returns are calculated using the period November 1, 2007, through February 28, 2009.

Fund Listings

Table 2 on pages 14 through 21 shows the top funds for each category. In addition to five-year performance, returns are displayed for each of the past 10 years, the current bull market and the past bear market. Returns that are in the top 25% of all funds within the investment category are shown in boldface. Other pertinent information is presented, including yield, tax-cost ratio, risk, portfolio composition and expenses. Risk and expense numbers that are in the lowest 25% of all funds within the investment category are shown in boldface.

Look Beyond Performance

The temptation is always to look primarily at performance. Though overall return is important, the relative consistency of performance also matters. For example, Fairholme (FAIRX) is ranked only third best among large-cap stock funds based on five-year average return. On an annual basis, however, it has ranked within the top 25% of its category (numbers in boldface in Table 2) during eight out of the past 10 years—an impressive performance.

Be sure to take the extra step of looking at how long the current manager has been running the fund. The online version of this article, available at AAII.com, shows when the current manager started. (For space reasons, we could not include it in the print version of this article.) If there has been a recent change in who manages the fund, future comparative performance may change. In the case of FAIRX, current manger Bruce Berkowitz has been at the helm for more than a decade.

Risk also plays a role. As previously noted, higher risk index scores suggest a fund has historically experienced a greater amount of volatility. Risk is relative, however. The small-cap stock fund Janus Triton T (JATTX) appears volatile with a total risk index of 1.23. Conversely, its category risk index is just 0.92, shown in boldface in Table 2 to denote that this number is in the lowest 25% for its category. This means that though JATTX has experienced a higher level of volatility, its performance has been less volatile than the average small-cap stock mutual fund.

Costs Matter

Lower expenses are always preferable, though—as with performance—costs are relative. A mid-cap domestic stock fund is cheaper to operate than a global stock fund. As a result, the 0.84% expense ratio for mid-cap stock fund Meridian Growth (MERDX) is not comparable to the 1.03% expense ratio for global stock fund Janus Global Select T (JORNX). Rather, the expense ratio for a given fund should be compared against its category average. (Both MERDXand JORNXcharge shareholders less than their category peers; their boldface numbers in Table 2 denote expense ratios in the lowest 25% for their respective investment categories.)

In addition to the expense ratio, a maximum load may be listed. A load is a fee charged for buying (front load) or selling (rear load) a fund. These fees are often reduced or waived if the fund is held for a certain period of time or if a certain amount is invested. Check with the mutual fund for the specifics.

If the mutual fund is held in a taxable account, the tax-cost ratio should be considered. Since mutual funds are comprised of pooled investment dollars, net capital gains are passed onto shareholders of record at the time the fund sold the security. Shareholders must pay taxes on these gains, regardless of whether they sold shares of the mutual fund itself or not, and regardless of how long they have owned the mutual fund.

Portfolio turnover plays a role in both expenses and tax costs, with higher levels indicative of more active trading by the fund manager. Investors seeking lower costs and/or less tax exposure may want to opt for funds with lower portfolio turnover ratios.

If costs or tax efficiency are the most important characteristic to you when looking at mutual fund, consider an index fund. Because these funds track an index rather than relying on the skills of an active manager, their costs tend to be lower. A few index funds are beating their category peers in terms of five-year performance, including Vanguard Long-Term Bond Index (VBLTX). (For a comprehensive listing of mutual funds, including index funds, consult the February 2011 AAIIJournal online at AAII.com.)

Further Evaluation

Before investing in any fund, read the prospectus. Have a clear understanding of the fund’s objective, strategy, risks and cost structure.

Next, obtain the latest fund report and review the holdings. What does the fund hold? How much of the portfolio is concentrated in each of the key holdings? If the fund manager provides commentary, read it to get additional insight into the thought process.

Finally, remember that even though mutual funds are intended to be long-term holdings, you should never buy them and forget about them. Like any investment, mutual funds should be periodically monitored to make sure the objective has not changed and the fund is performing as expected given prevailing market conditions and historical performance. Do not only pay attention to current performance, but also consider current performance relative to historical performance and relative to the fund’s category average. A fund that lags in market conditions that it historically has done well in should receive more scrutiny than a fund that is following its historical volatility trends and is producing similar returns to those of its peers.