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, where we want to see confident managers who have a track record of success, assemble their portfolios using a sound and time-tested strategy, and have plenty of their own money in the fund.

We also fervently favor funds with reasonable expense ratios. Shannon Zimmerman, analyst of 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 his benchmark and rivals.

Finally, the fund will need a reasonable-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 counts AT&T and Google among its top holdings.

These are solid companies, no doubt, but these large caps don't have the same chance at outsized gains as their smaller brethren do. Here are just three of the market's 10 best stocks over the past 10 calendar years. The important point is they all started the decade with market caps considerably less than $1 billion.

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 like Fannie Mae and Philip Morris (now Altria).

Shannon has shown a knack of his own for identifying winners. His official recommendations are beating the market and relevant benchmarks 31% to 18% since the service began. He also highlights potential champions in his "Up & Coming" feature. Some of these may turn into official recommendations in the future, but bear watching for the time being.

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 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), right now, 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 authentic Icelandic skyr. He does not own shares of any company mentioned. Starbucks is a Motley Fool Stock Advisor recommendation. Here's the Fool's disclosure policy.