When Janet Brown is selecting mutual funds, she looks past the traditional criteria that most other fund pickers use, such as how low the fees are, how experienced the fund managers are and even how good the long-term performance has been. Instead, she focuses on something that other fund pickers say can be misleading—short-term performance.

Her strategy is called “upgrading.” She regularly identifies the mutual funds that are performing best, then adjusts the model portfolios in her NoLoad FundX newsletter to continue to own just the top performers.

Brown, who oversees $1 billion in assets and publishes one of the highest-ranked investment newsletters, says it is an approach that has been proven to work.

Over the past 20 years (as of December 31, 2012), her Class 3 portfolio, which she says is a core portfolio best-suited for moderately aggressive long-term investors, has returned an average of 11.5% a year versus 8.2% for the Standard & Poor’s 500 stock index. Her most aggressive portfolio, Class 1, has returned 13.7% a year, on average.

Bottom Line/Personal spoke with Brown to find out how our readers can use upgrading to improve their own investment returns…

WHY UPGRADING WORKS

Back in the 1970s and 1980s, I was perpetually frustrated by how difficult it was to find a great mutual fund that I could just buy and hold. Even the best funds tend to have a particular style of investing that may go in and out of favor for many years at a time. Or a fund’s success would attract a flood of new money that hindered the manager’s ability to invest optimally. Further complicating matters, I needed to find not just one great fund but several to own a diversified portfolio, and that made the prospects for success even more remote.

A better way: Upgrading grew out of academic studies about a well-documented investing phenomenon known as “persistence of performance”—the returns of stock funds that have performed well in the most recent trailing year tend to continue to be superior performers in the near-term future (typically the next 12 months) before cooling off.

HOW TO UPGRADE

In one form of upgrading, you buy the top-five best-performing mutual funds and exchange-traded funds (ETFs) of the previous 12-month period, allocating 20% of your stock portfolio’s assets to each. You hold these funds for one year and then repeat the process, selling off any funds that you own whose returns are no longer the best and replacing them with better-performing ones.

I don’t worry about the annual expenses that top-performing funds charge because that’s already reflected in their returns. But I avoid using any funds that charge a load or a commission.

In order to provide the appropriate levels of volatility for investors with different risk tolerances, I compare and rank performance among funds that have similar risk levels—rather than focusing on the sizes of the companies that they invest in or on whether the funds invest in US or foreign stocks—and I group those together into four risk classes. I do this based on various factors, including each fund’s investment strategy…diversification…past record in down markets…and standard deviation.*

Helpful resources: You can use Morningstar.com or Finance.Yahoo.com to research these elements.

NOT FOR EVERYONE

Upgrading is not for everyone, especially if you have favorite funds or fund managers or feel uncomfortable replacing much or perhaps all of your portfolio each year.

And if you do use this strategy, you still will need to make asset-allocation decisions regarding how much of your portfolio you want in stocks versus, say, bonds and cash.

Also, this strategy requires patience and discipline because, although you repeatedly are moving into the funds that are doing well and out of funds that are not, you won’t beat the broad market indexes every year.

For example, in the 2002 stock market plunge, my core portfolio beat the S&P 500, which lost 22%, by eight percentage points because I was heavily invested in areas of the stock market that did well that year, especially small-cap value funds.

However, 2008 was a different story. My core portfolio fell by 40%, while the S&P 500 lost 37%. There were few positive areas of the market to upgrade to. Most mutual funds suffered big losses.

A BETTER VERSION

There is another form of upgrading that tends to produce even better returns, as much as one to two percentage points higher annually, on average, over the long term.

How it works: Instead of choosing funds once a year by examining their 12-month trailing returns, look at four different performance time periods—the trailing one-, three-, six- and 12-month returns. Add up these four performance figures, and divide by four to get an average number you can use to compare top funds. By including shorter time periods, you pinpoint whether the market trend behind a fund is strengthening or weakening.

FUNDS TO BUY NOW

In 2013 so far, market leadership has leaned heavily toward small- and mid-cap stocks and dividend-paying stocks in US markets. Foreign stock funds with exposure to Japanese stocks were leading the pack for months but have fallen as the Nikkei Index pulled back sharply.

Core stock holdings for the next 12 months based on my upgrading system using the four-period method…

Ariel Investor Fund (ARGFX). Performance: 34%.**

Dodge & Cox Stock Fund (DODGX). Performance: 35%.

Oakmark Global Fund (OAKGX). Performance: 32%.

Sound Shore Fund (SSHFX). Performance: 33%.

Wells Fargo Advantage Special Mid Cap Value Fund (SMCDX). Performance: 35%.

Aggressive holdings for the next 12 months…

Ariel Appreciation Fund (CAAPX). Performance: 37%.

Baron Partners Fund (BPTRX). Performance: 36%.

Fidelity Leveraged Company Stock Fund (FLVCX). Performance: 36%.

Primecap Odyssey Aggressive Growth Fund (POAGX). Performance: 34%.

Skyline Special Equities Portfolio (SKSEX). Performance: 40%.

* Five-year standard deviation is a common gauge of risk that measures how much a fund’s yearly returns tend to swing above and below its average annualized long-term performance over the trailing five years.

** Performance is based on returns over the past 12 months as of June 30, 2013.