The Next Great Mutual Fund

You've heard of the man, and you've heard of his mutual fund. From 1977 to 1990, Peter Lynch guided Fidelity Magellan to legendary status. He smashed the market averages and generated nearly 30% annual returns for his shareholders. Anyone dropping $10,000 into Magellan back then would have seen it grow into some $300,000 in 13 short years.

We're all looking for the next Magellan. But with a dizzying array of mutual funds out there, it's impossible to know where to look. Or is it?

Great funds in the making
If we wanted to identify an up-and-coming fund, what would we look for?

Let's start at the top. We'll want to see a confident manager who has a track record of success, assembles the portfolio using a sound and time-tested strategy, and has plenty of his or her own money in the fund.

We also fervently favor funds with reasonable expense ratios. Shannon Zimmerman, lead analyst at Motley Fool Champion Funds, tells us that few statistics relate more strongly to future performance than this one. Extra costs simply represent extra ground that the fund manager has to make up each year just to stay even with the fund's benchmark and rivals.

Finally, the fund will need a reasonably sized asset base, one that gives the manager enough flexibility to build meaningful positions (and exit them) without fear of moving stock prices in the wrong direction -- that is, up when buying and down when selling.

One thing's for sure: Magellan itself can't be the next Magellan. It has morphed into a giant that owns some of the world's largest firms. These are solid large-cap companies, but they don't have the same chance at outsized gains as their smaller brethren do.

Fidelity Magellan Major Holdings

Up and coming
There's a lot more to finding the next Magellan than all that, of course. We admit that Lynch combined intelligence, common sense, and even a knack for playing hunches in a way that's hard to match. In his everlasting pursuit of what he called "10-baggers," he unearthed monsters such as Philip Morris, now Altria.

Shannon Zimmerman has shown a knack of his own for identifying potential fund winners. His official recommendations are beating the market and relevant benchmarks 40% to 24% since the service began. He also highlights potential champions in his "Fund Watch" feature. Some of these may turn into official recommendations in the future, and they bear watching for the time being.

A recent issue, for example, highlighted a new fund with a manager who helped his previous fund put up some terrific performance numbers -- a 450% total return over an eight-year period.

And the winner is ...
The next Magellan is out there, right now, with huge gains ahead of it. But it's not an index fund, and it's not even Magellan itself. Not for nothing did Fidelity recently shuffle the management deck at Magellan, which -- in an effort to staunch the inflow tide -- is currently closed to new money.

Instead, the next great mutual fund is being led by a smart manager who doesn't have to overcome outrageous fees or contend with an outsized asset base that undermines his or her stock-picking strategy.

You can read more of Shannon's thoughts on great mutual funds, and see all of his recommendations (smaller, nimbler funds among them), by signing up for a 30-day free trial. There is no obligation to subscribe.

This article was originally published on Jan. 20, 2006. It has been updated.

Rex Moore will write for food ... preferably doughnuts. Of the companies mentioned in this article, he owns shares of Johnson & Johnson, which is an Income Investor recommendation. Here's the Fool's disclosure policy.