FBR Small Cap Financial

( FBRSX),

Burnham Financial Industries

(BURFX)

and

Mutual Financial Services

(TFSIX) - Get Report

have accomplished mission impossible: beat the benchmark

S&P 500

index.

The mutual funds steered clear of riskier stocks and held cash. During the 12 months ending May 21, financial funds lost 38.1% of their value, while the S&P 500 dropped 34.4%, according to Morningstar. Financial funds would have slumped even more were it not for the rebound that started in early March.

Citigroup

(C) - Get Report

shares, for example, quadrupled in a matter of weeks after declining to less than $1.

Bank of America

(BAC) - Get Report

is trading at around $11 after falling to as low as $2.53 at the end of February.

FBR Small Cap Financial, Burnham Financial Industries and Mutual Financial Services could make interesting choices for investors seeking cautious ways to bet on a revival of financials.

FBR Small Cap Financial fell 5% in the past 12 months. To protect shareholders, manager David Ellison had 57% of assets in cash at the end of 2008. Under normal conditions, he holds little cash. But last year he correctly determined that rising defaults presented extreme hazards. "When nonperforming loans are rising, bank stocks don't do well relative to the market," he says.

Ellison learned the virtue of taking special precautions during the late 1980s, when he managed

Fidelity Select Home Finance

(FSVLX) - Get Report

, which focuses on mortgage lenders. At the time, overbuilt real estate markets suffered high vacancy rates and many savings and loans collapsed.

Despite the troubles, most fund companies clung to their traditional strategies, staying invested in stocks. But Peter Lynch and other aggressive managers at

Fidelity Investments

believed in ranging widely, following different strategies as conditions warranted. Lynch, who managed

Fidelity Magellan

(FMAGX) - Get Report

, bought large financial stocks one year and small consumer companies the next.

When Ellison expressed his concerns about banks, Fidelity managers encouraged him to take dramatic steps and shift to cash. The strategy worked. When he left Fidelity in the 1990s, Ellison ranked as one of the top-performing fund managers.

These days, Ellison argues that long-term investors should buy financial shares. "During the next five or seven years, the fundamental performance of banks will improve from ugly to OK and then to great," he says. "The best time to own the stocks should be during the next couple years, when the banks move from ugly to OK. That's when you will see some stocks tripling."

A favorite holding is

Hudson City Bancorp

(HCBK)

, a growing community bank in Paramus, N.J. The bank has enough capital to survive the recession and continue expanding, Ellison says.

Ellison says the outlook for banks is improving because sensible thinking has returned to the markets. Customers are no longer buying houses simply because prices are going up. Banks are only making loans to people who can afford them. With interest rates low, the volume of mortgage activity is healthy, Ellison says. "We don't have a credit crunch right now," he says. "We have credit standards returning to normal."

Burnham Financial Industries returned 1.2% in the past year. Manager Anton Schutz managed to stay in the black by holding cash and avoiding weak institutions in troubled markets such as Nevada and Florida.

The fund has 20% of assets in cash, and Schutz is emphasizing well-capitalized banks. A big holding is

People's United Financial

(PBCT) - Get Report

, which is based in Bridgeport, Conn., and provides retail and commercial services. "They are sitting on $2.5 billion in excess capital," Schutz says. "They are in a position to buy other banks that have been hurt by nonperforming loans."

Another holding is investment bank

Lazard

(LAZ) - Get Report

. Because it avoided big losses in the past year, Lazard wasn't forced to take government bailout money. That has left the firm free to pay high salaries and recruit top talent from hobbled competitors, Schutz says. Now Lazard is positioned to be a leader in the burgeoning business of advising companies about restructuring.

When he sees opportunities, Schutz is free to sell short, betting that stocks will fall. Last year he shorted Puerto Rican banks, figuring the island's weak economy would hurt profits. The trades proved profitable.

A big cash position helped Mutual Financial Services outdo the S&P 500 by 3 percentage points in the past year. Manager Charles Lahr has 38% of assets in cash. A diehard contrarian, Lahr often avoids well-known names and holds unloved shares selling at fat discounts. A big holding is

White Mountain Insurance

(WTM) - Get Report

, a property and casualty insurer. Lahr holds a broad mix, including distressed bonds and foreign stocks.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.