3 Mutual Funds for an Improving Economy

Tickers in this article: CAAPX PARSX PTSGX

NEW YORK (TheStreet) -- Investors have become optimistic about the economy. As a result, this year's best-performing mutual funds have included cyclical mutual funds that get a big boost when the outlook for growth improves.

Top mutual fund categories include technology, which has returned 16.0% in 2012, and financial, with a return of 13.1%, according to Morningstar. In comparison, the S&P 500 has gained 9.3%. Utilities funds -- which don't gain much from economic booms -- have only returned 0.8%.

This year's showing represents a big turnaround from the performance of last year when investors feared that the economy was headed for a recession. For protection, investors poured into utilities, while technology and financial funds suffered sizable losses in 2011.

If the economy continues growing, the current market leaders are likely to maintain their momentum. So bullish investors should consider emphasizing mutual funds that have big stakes in cyclical sectors.

To find mutual funds that seem poised to do well when markets are rising, I looked for portfolio managers with strong long-term records and big positions in cyclicals.

For some extra oomph, I also searched for mutual funds that tend to rise hard when stocks climb. Such bull-market stars score high on a measure known as upside capture ratio, which is calculated by Morningstar and other data suppliers.

If the S&P 500 rises 10%, a fund that climbs 11% is said to have an upside capture ratio of 110%. Funds with high upside capture ratios can be risky, but they can produce rich rewards in strong markets.

Funds that made the cut included Ariel Appreciation , Parnassus Small-Cap and Touchstone Sands Capital Select Growth .

Touchstone, a high-octane choice, has returned 17.3% this year, outdoing 97% of competitors in the large growth category. The fund has an upside capture ratio of 127%.

During the past five years, Touchstone has returned 9.1%, outdoing 98% of competitors. The portfolio managers achieved the compelling record by focusing on leading companies that can continue growing for years to come. To buy champion businesses, the fund is willing to pay high prices.

The portfolio has 28% of assets in technology stocks and 23% in consumer cyclicals. Technology holdings include such growth stars as Google and business software provider Salesforce.com . A cyclical holding is coffee retailer Starbucks .

"Starbucks is growing globally, and it has become better at controlling costs," says Tim Paulin, Touchstone's vice president of investment research.

The portfolio managers of Ariel Appreciation are value investors in the mode of Warren Buffett. The managers aim to find solid companies that have clear advantages, such as strong brands, low costs or dominant market positions. The fund prefers growing companies with little debt. The aim is to buy the stocks when they are temporarily depressed and sell for discounts of 40% to their fair values.

The high-quality value names in the portfolio lagged last year, but they have come roaring back lately. So far in 2012 the fund has returned 13.0%, outdoing 88% of funds in the mid-cap blend category. During the past five years, Ariel returned 3.5% annually, outdoing 66% of peers. The fund has an upside capture ratio of 137%.

The financial crisis presented many opportunities for the Ariel managers, as high-quality stocks slipped to depressed levels. In 2008 and 2009, the fund added upscale retailers, including Nordstrom and Tiffany , which had sunk badly. The purchases proved to be on target, as the economy improved and stocks rebounded.

"We got those excellent companies on sale because people were thinking that no one would ever spend again," says portfolio manager Tim Fidler.

The fund currently has 31% of assets in consumer cyclicals and 28% in financial services. There are no assets in utilities.

"Utilities have the qualities that we don't want," says Fidler. "They have very little growth and huge capital requirements."

Fidler owns CBS . The shares sank as investors worried that broadcast television would decline along with other kinds of old media. But TV advertising is rebounding strongly, Fidler says. Sales this year should get a boost from political advertising.

Parnassus Small-Cap looks for socially responsible companies with secure niches and shares that sell for one-third less than the fair values.

With 35% of assets in technology and 11% in consumer cyclicals, the fund has returned 13.6% this year, outdoing 93% of peers in the small blend category. During the past five years, Parnassus returned 7.4% annually, outdoing 96% of small blend peers. The fund has an upside capture ratio of 136%.

Parnassus holds PulteGroup , a homebuilder that was slammed in the financial crisis and sank again last summer.

"The housing market is starting to come back," says Parnassus portfolio manager Jerome Dodson. "But the stocks are still so depressed that they sell at bargain prices."

Dodson also likes clothing maker Hanesbrands . Earnings suffered when cotton prices spiked last year. But cotton has been falling lately, and the company has said that it will spend its increasing cash flow on paying down debt. That should boost the shares, says Dodson.

Tickers in this article: CAAPX PARSX PTSGX