Top Funds for Your 2011 401k

As we close out a turbulent, yet rewarding year for 401k investors, what better time to begin taking a serious look at how your retirement account is positioned for the year ahead.

Now to be certain, if 2011 is anything remotely close to 2010, we are going to see a lot more flux in equities. That said, I also suspect that we’re going to see more upside in stocks of all stripes — and that could turn out to be very good for the well-thought-out 401k portfolio.

So, what funds should you have exposure to as we ring out the old and begin the New Year?

Here are six of my favorite mutual funds and ETF funds for 2011.

#1 – Vanguard Dividend Growth (VDIGX)

Large-cap dividend payers were underwhelming in 2010, and the stock picks of Vanguard Dividend Growth (MUTF: VDIGX) manager Don Kilbride were underwhelming as well. In fact, after a three-year run of strong outperformance, Kilbride has lagged for the last two.  That said, Dividend Growth’s long-term performance remains well above its benchmark, and it’s always good to invest with a top-notch manager when they’re down because the rebound can be doubly strong.

The differences between this fund’s portfolio and that of most index funds focused on dividend-payers is that Kilbride has the flexibility to go overseas, and he’s done so, putting as much as 15% of the fund’s assets in foreign stocks (the current allocation is just over 6%). With domestic markets outperforming, it’s a good bet that some of Kilbride’s holdings got swept along in the current foreign market pessimism. More importantly though is the fact that Kilbride’s portfolio consists of fewer than 50 stocks. In other words, when Kilbride’s right on a stock or two, he’s going to be very right, and when wrong, which isn’t often, it’s going to hurt.

Some of the top holdings in VDIGX include corporate behemoths Automatic Data Processing (NASDAQ: ADP), Johnson & Johnson (NYSE: JNJ) and Medtronic, Inc. (NYSE: MDT).

I’ve got confidence that Kilbride and his analysts and colleagues at Wellington Management will begin to outperform again. Whether it comes in the next month or in several, this is one fund that meets many of my criteria for a winner, with a single manager, tight portfolio and strong track record and resources to back it up.

#2 – PRIMECAP Odyssey Aggressive Growth (POAGX)

The PRIMECAP Odyssey Aggressive Growth (MUTF: POAGX) invests in common stocks of companies expected to show rapid earnings growth.  However, the managers don’t pay up for growth, preferring to identify companies where they feel a catalyst is in the offing, but hasn’t been reflected in current stock prices. I believe this fund is going to be a long-term winner (it’s my single largest personal holding) thanks to its management, led by Theo A. Kolokotrones, President and Co-Founder of PRIMECAP Management Company.  The strength of the PRIMECAP team lies in their consistency, among other things. While they only outperform their index benchmarks about six of every 10 months, when they do outperform, they more than make up for months when they lag these same benchmarks. Periods of underperformance are perfect opportunities to add to holdings. Of course, if you’re a long-term investor like me, periods of outperformance are also great for adding to holdings.

Some of the fund’s top current holdings are in the biomedical sector, a market segment with tremendous earnings growth potential. The fund currently holds Crucell NV (NASDAQ: CRXL), Dendreon Corporation (NASDAQ: DNDN) and Cepheid (NASDAQ: CPHD), all high-profile biotech stocks with potentially huge earnings as well as huge upside. If you don’t have an aggressive growth component in your 401k component in 2011, then POAGX is definitely one to consider for 2011.

#3 – Fidelity Low-Priced Stock (FLPSX)

Manager Joel Tillinghast has rarely owned less than 800 names, and often he owns more than 1000. At last count, the Fidelity Low-Priced Stock (MUTF: FLPSX) held 907 stocks.  Tillinghast buys stocks priced at $35 a share or less, which increases the likelihood of small- and mid capitalization investments in bull markets but can net him companies of virtually any size in bear markets.

Normally I’m wary of huge portfolios like Tillinghast’s, but his long-term track record—which reaches back to 1989’s market collapse and banking model meltdown—has been one of solid, consistent performance, particularly when markets and economies find a bottom and begin climbing out of a trough. And he’s built that record on his massively diversified portfolio.

The top holdings in FLPSX come from a variety of sectors, including health care services, consumer services and technology. Companies such as UnitedHealth Group Inc. (NYSE: UNH), Lincare Holdings Inc. (NASDAQ: LNCR), Oracle Corporation (NASDAQ: ORCL) and Safeway Inc. (NYSE: SWY) top the list of the diverse equity exposure in FLPSX.

#4 – Vanguard Emerging Markets ETF (VWO)

It’s risky, and volatile, but the emerging markets are the growth engines of the global economy. As such, a good 401(k) will contain some exposure to this dynamic market segment, and Vanguard Emerging Markets ETF (NYSE: VWO), which tracks the MSCI Emerging Markets Index, is a great way to get it.

The index this fund tracks has changed over the years with countries added and eliminated. Stocks in Brazil, China, India, South Korea and Taiwan represent more than 65% of the fund’s assets at present. And foreign “big-oil” is a major influence on the index, with major producers among the top holdings. In fact, this fund provides tremendous exposure to the energy business without having to invest in an energy sector fund.

Some of the biggest holdings in the fund read like a who’s who of emerging market corporate giants. Companies such as Brazilian mining firm Vale (NYSE: VALE), oil and exploration company Petroleo Brasileiro (NYSE: PBR), premier Asian telecom stock China Mobile Ltd. (NYSE: CHL) and Latin America wireless communications firm America Movil SAB de CV (NYSE: AMX).

Now, because VWO is an exchange-traded fund, you’ll have to use your brokerage option in your 401(k).  Of course, I realize that not all plans offer a brokerage option. But the fund also has open-end shares, ticker VEIEX, which may be available in your plan and are fine to use as a substitute for the ETF shares, though they charge 0.50% front-end and 0.25% back-end “purchase” and “redemption” fees. Also, don’t overdo it on your emerging markets allocation. Many of the larger companies you already have in your portfolio have exposure to the emerging markets through their foreign sales and earnings. A 5% to 10% position here would be aggressive.

#5 – Vanguard International Growth Investor (VWIGX)

I always considered Vanguard International Growth Investor’s (MUTF: VWIGX) former lead manager Richard Foulkes one of the best of the breed among international investors. Since Foulkes retired almost five years ago, Virginie Maisonneuve has ably taken over Foulkes’ approximately 45% portion of this $15 billion portfolio.

The fund has three managers, with Baillie Gifford handling another 45% of assets and M&G Investment Management handling about 10% or so. What’s encouraging about the fact that there are three management teams on this  portfolio is that it hasn’t exploded to hold hundreds of stocks—it currently has about 180 or so, including companies like Chinese Internet giant Baidu, Inc. (NASDAQ: BIDU), Israeli pharmaceutical company Teva Pharmaceutical Industries (NASDAQ: TEVA) and international consumer conglomerate Unilever Nv/Plc. The top 10 holdings make up about 17% of assets. That’s a good sign of manager conviction, and a whole lot better than buying into a foreign-stock index fund.

With growth stocks presenting some decent opportunities, this fund is a good option as a core foreign holding, particularly given its 25% stake in emerging markets. If international stocks prove to be big winners again in 2011, exposure to this well-managed, diversified international growth fund will be a key component to substantial 401(k) performance going forward.

#6 – Short-Term Investment Grade (VFSTX)

This is my favorite Vanguard fund at the short end of the yield curve. Formerly called Short-Term Corporate, it is extremely safe, produces steady returns, and offers some diversification away from plain-vanilla Treasury funds. Rather than investing only in Treasury, Agency or other government-backed securities, Short-Term Investment-Grade (MUTF: VFSTX) invests in high-quality corporate bonds, asset-backed bonds and a smattering of other non-Treasury securities. The combination responds to rising or falling interest rates less rapidly than Treasurys, meaning that it rises a bit slower when rates drop and falls a bit less when rates rise, since its excess yield protects investors and prices. Over time, a portfolio like this one will outperform a Treasury portfolio, as this one has.

I use this fund as a higher-yield cash substitute and would recommend it in that role for most any retirement portfolio invested for the long haul. Of critical importance from a portfolio diversification/safety standpoint is that while the fund can lose and has lost money in bond market routs, its short duration means it drops less than funds holding bonds of longer maturities and, because of rising yields in its portfolio, begins recouping its losses with larger income streams faster. When interest rates backed up from their recent Nov. 4 lows, Short-Term Investment-Grade lost just 1.3% (data is through 12/20) versus 3.0% for the overall bond market.

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