For the benefit of newcomers, here's an explanation of our Fund Upgrading strategy and why it has led to superior long-term returns.

In Indexing: The Loser's Game That Can Make You A Winner, we explained how to use low-maintenance index funds to produce market-matching returns. Indexing is a solid strategy that works well for many investors. But if you want to try to "beat the market" rather than just match the market, a more hands-on approach is required.

To outperform the market you must be willing to adjust your holdings regularly, seeking to own only those funds demonstrating relatively superior results at any given time.

All three of SMI's most popular strategies — Fund Upgrading, Dynamic Asset Allocation, and Sector Rotation — rely on momentum for their investment selection. The universe of potential investment choices and the exact formula we use to rank those choices varies among these strategies, but the same principle drives all three. We will focus on Upgrading in this article, given that it is SMI's oldest and most popular approach. But many of the principles covered here also apply in some fashion to DAA and Sector Rotation as well. (See Higher Returns With Less Risk: The Best Combinations of SMI's Most Popular Strategies for our suggestions on how and why you might want to use these three strategies in combination.)

The premise of Upgrading is simple: it is a gradual fine-tuning process, whereby we invest in currently top-performing funds in each of several risk categories, then sell a fund when it surrenders its place of leadership.

Upgrading takes advantage of certain long-observed realities of the market. As economic conditions and expectations change, market leadership will rotate among large-, medium-, and small-sized companies. Likewise, changing conditions and expectations naturally will favor some investment strategies over others. At times, a cautious value strategy is best; at other times aggressive growth investors are rewarded. But even though market conditions change, most fund managers don't. Managers trained to invest in large growth companies (for example) can't change their philosophical stripes overnight and turn into small-cap value managers just because that sector is strong at the moment. For the most part, they just keep doing what they believe in and have been hired to do — invest in the shares of large growth companies.

These market and management realities explain why mutual-fund performance leadership rotates. And it's why numerous academic studies show that few funds can consistently perform in the top ranks year after year. By implication, these studies suggest there is little predictive value in using long-term past performance as a basis for forecasting how a fund might perform over the next 6-12 months.

The best approach, then, is not to "pick a great fund and hold on to it for many years." Put bluntly, strategies that rely heavily on a fund's long-term track record (typically three to five years) in selecting "all-weather performers" that you can buy and supposedly forget about — such as Forbes' Honor Roll, Consumer Reports' recommended funds, or Morningstar's well-known "star system" — rarely result in superior returns. Staying with one particular fund is simply unlikely to result in outstanding performance over the long haul.

But a significant amount of academic research (as well as SMI's years of first-hand experience) suggests there is value in concentrating on a fund's more-recent track record as a predictor of future success. Specifically, performance from the past 6-12 months tends to persist, whether good or bad. Therefore, it seems prudent to initially invest in a top-performing fund that's been doing an excellent job in recent months. When that fund eventually falters (and it will), it will be time to exchange it for one of the new leaders.

How do we do this? Building on the pioneering work in this area by Burton Berry, founder of a helpful mutual-fund newsletter called NoLoad FundX, we developed a similar formulaic approach (which we refer to as "momentum") that we use for ranking the performance of mutual funds. These momentum-based rankings, available in our Fund Performance Rankings, provide the basis for SMI's fund selections in the Upgrading strategy.

Upgrading's momentum scores are easy to calculate — simply add up a fund's most recent 3-month, 6-month, and 12-month performance. Notice that the most recent three month's performance is reflected in all three figures. It represents 100% of the first number, 50% of the second number, and 25% of the final number. In this way, a fund's most recent performance is given greater weight. Stated another way, our performance momentum calculation counts each fund's most recent three-month performance three times more than it does the 12th month back. This formula reflects our belief that (1) the older the performance data, the less relevant it is, and (2) more recent months should be weighted more heavily than distant months.

Look at it this way. As the baseball season hits the mid-way mark, who is more likely to win the World Series this year — ­the team that has won the most games over the past five years or the team that has been the most dominant this year? In sports, the teams that have been strongest of late are the more likely winners in the coming months. The same is true in the world of mutual funds, and our momentum calculation is one good way to identify the contenders for the performance title.

When selecting Upgrading's recommended funds, we first place each stock fund that we follow (more than 900 in all) in its proper risk category, then rank them according to their recent performance momentum. In this way, we compare a fund's momentum only against funds of the same type (large/growth against other large/growth funds, etc.). We rule out funds with characteristics that make them unsuitable for our purposes — such as those that assess loads (commissions charged by the funds when you buy them), are closed to new investors, aren't available through the brokerage firms we recommend, or that have higher relative-risk scores than we are comfortable with. This "winnowing" process doesn't mean the funds we've eliminated won't prove to be good performers in the coming months; it simply means they don't fit our needs.

Ultimately, we settle on three finalists in each risk category and highlight them on our current "recommended" list. Each month, using the latest data, we repeat the momentum-ranking process. After initially being recommended, we're content to hold a fund as long as it continues to be ranked in the top one-fourth of its peer group. A fund that falls out of the top quartile usually is sold and replaced. (A replacement is chosen from among the current leaders in the same risk category.)

To see our current Upgrading recommendations and for details on how to set up an Upgrading portfolio, see our How to Implement section under our Fund Upgrading Strategy.