Dec. 31 (Bloomberg) -- Mutual funds investing in U.S. equities are likely to end 2004 with an average 12 percent gain, about a third of last year's increase, after higher oil prices and interest rates curbed advances in the stock market.

The funds struggled to eke out an average 3 percent gain during the first 10 months. The benchmark Standard & Poor's 500 Index limped at half that pace while oil prices surged to a record $55 a barrel, according to data compiled by Bloomberg.

Fund managers got a boost in November and December as a decline in oil prices spurred gains in shares of health-care companies and Internet retailers. Legg Mason Value Trust's Bill Miller was poised to extend his streak of beating the S&P 500 to a record 14th year in the last week of December after Amazon.com Inc. reported record holiday sales.

``It was a tough year to get the return,'' said Hans Olsen, 42, who manages $2 billion as chief investment officer at Bingham Legg Advisers in Boston. ``In 2004, if you produced market-beating performance, you worked hard to get it.''

Mutual fund returns will continue to be tough to come by in 2005. The Federal Reserve's five increases in the overnight bank- lending rate this year raised companies' borrowing costs, damping investor expectations about earnings growth. The Fed is expected to continue to raise rates next year, Olsen said.

The average increase in earnings is ``starting to wind down,'' said Gus Sauter, 50, chief investment officer of Valley Forge, Pennsylvania-based Vanguard Group, the second-largest U.S. mutual fund company. ``We're just cautioning that returns will be less.''

Stock returns will be between 7 percent and 9 percent annually over the next five to 10 years, Sauter said.

Market Rally

The average equity fund increased 34 percent in 2003, when the S&P 500 Index's total return, including dividends, surged 29 percent, according to Bloomberg data. The benchmark index climbed 9.1 percent this year, as of Dec. 29.

Last year's stock market rally put an end to a three-year bear market, encouraging U.S. investors to add a record $330 billion to equity and balanced funds this year, according to data from Strategic Insight, a research firm in New York.

``We saw an anomalously robust rally in 2003,'' said James Lowell, 44, chief investment strategist at Adviser Investment Management. ``I would be surprised if anyone heading into 2004 would have expected to duplicate the rally from the trough heading into 2003.''

American Funds, the largest U.S. mutual fund company after Fidelity Investments and Vanguard, was on pace to be the best- selling firm for the third straight year, according to Financial Research Corp. The unit of Los Angeles-based Capital Group Cos. took in $75.6 billion in the first 11 months, FRC said.

Top Performers

The best-performing stock fund was the $80 million Philadelphia Fund run by Donald Baxter, according to Bloomberg data. It returned 71 percent as of Dec. 29.

Among the biggest stock funds, the $90.8 billion Growth Fund of America gained 12 percent, outperforming 61 percent of similarly managed ones. Fidelity Magellan, with $62.6 billion in assets, returned 7.6 percent, trailing two-thirds of competitors.

Higher interest rates also trimmed the average return of bond funds, which rose 3.7 percent this year compared with 6.7 percent in 2003, according to Bloomberg data.

The $93 million American Century Target Maturities Trust Series 2025, which rose 34 percent, was the top gainer among bond funds. The second-best was the $13 million American Century Target Maturities Trust Series 2030 Fund, with a 19 percent return.

Fund Groups

Among investment strategies, natural resources funds such as the $799 million State Street Research Global Resources Fund were the top gainers in 2004, rising an average 30 percent, according to Bloomberg data.

``What attitude you had about energy was an important factor in how you did this year,'' said Gordon Fines, 59, San Diego-based manager of the $20 billion AXP New Dimensions Fund.

So-called value funds outperformed growth. Value fund managers select stocks they view as undervalued, while growth managers seek rising earnings.

Funds that invested in smaller-sized companies fared better than those favoring larger firms. The average large-cap value fund returned 13 percent through Dec. 29, trailing the 20 percent rise in small-cap value.

Small caps now ``are very expensive relative to the mega caps and the economic conditions are such that they are riskier,'' said Nikolaos Monoyios, 55, who helps manage $21.5 billion at OppenheimerFunds Inc. in New York.

International

Funds that invested in companies outside the U.S. returned 18 percent. The U.S. dollar, which fell against the euro and the yen this year, made companies abroad more favorable. The $62.8 million AIM International Emerging Growth Fund, the top performer among international equity funds, returned 34 percent, according to Bloomberg data.

``International stocks were cheaper than domestic stocks for the same kinds of businesses,'' said Chuck McQuaid, 51, who runs the $13 billion Columbia Acorn Fund in Chicago. The fund boosted its stake in foreign stocks to 15 percent from 8 percent this year.

To contact the reporter on this story: Danielle Kost in Boston at dkost1@bloomberg.net.

Last Updated: December 31, 2004 00:12 EST