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Mutual Funds: Only Gold Glitters

It hasn't been a good time for the stock market -- and many mutual funds have done even worse. Mara Der Hovanesian, BusinessWeek's markets and investments editor, reports that the average diversified stock fund fell by about 1.5 percentage points more than the S&P 500 in the third quarter -- the worst fund performance since 1987.

Only gold funds showed a positive return, Der Hovanesian says. Among other sector funds, real estate was flat and the rest declined. A few large Fidelity funds, mostly balanced funds, managed to do better than many of their peers -- in part because Fidelity managers started cutting back on technology stocks early in the year -- but they still lost ground.

According to Der Hovanesian, fund managers are trying to weather the storm by, among other things, focusing on smaller-cap stocks that have been hurt less and by looking more intensively at companies' balance sheets, product offerings, and management.

Der Hovanesian made the comments during a chat on Oct. 9 presented by BW Online on AOL, in response to questions from the audience and from BW Online's Jack Dierdorff. A full transcript is available from BW Online on AOL at keyword: BW Talk. Edited excerpts follow.

Q: Mara, how bad is it for the mutual funds? Worse than the market?

A: More than half of the actively managed stock funds have done worse than the market. And, on average, a U.S. diversified fund fell about 1.5 percentage points more than the S&P. This quarter has seen the worst performance in mutual funds since 1987. The sense is that stock mutual funds are going to end probably lower this year than they did last year....

Q: Has any type of fund done better? Some Fidelity funds are up.

A: Actually, the largest funds happen to be dominated by Fidelity funds. They did hold up in the quarter and have done well also this year. Almost two-thirds of their stock funds were ahead of their peer groups in similar funds. Mainly, they are balanced funds, or hybrid funds that have some bond component, or have dividend-yielding stock -- for instance, the Fidelity Growth & Income Fund.

Q: Any clues as to how Fidelity managed that? What did they do that other funds didn't?

A: Fidelity as a whole, as a fund shop, has cut back a lot of its tech holdings, and has been buying more defensive stocks, such as health-care stocks. They really started cutting back tech in earnest in the earlier part of the year.

Q: So with these dismal returns for most funds, have investors been cashing out in droves?

A: They're not necessarily cashing out in droves, although it's estimated that in the third quarter about $35 billion came out of stock funds -- the most since 1998. It's a lot in dollar terms, but in terms of percentages -- in a $7 trillion industry -- it hasn't reached alarming proportions. More investors are doing what they typically do in downturns: One, buying fewer equity funds.... Two, opting for safer havens such as bond or money-market funds.

Q: You're talking double-digit losses here for lots of funds -- but I notice a few sector funds have done a bit better.

A: The thing that's done the best...has been gold.... Basically, every other sector is in the red. Real estate has held up -- they're flat. That's better than being down 20%. And science and tech, the worst-performing sector of all, is down over 55% this year.

Q: How have Janus funds been faring?

A: Not well. They're not bottom of the barrel, but a concentrated growth style that favors tech stocks hasn't been a winning strategy this year. One of the worst-performing funds at the shop has been their flagship. Janus Fund, which has the most investors at almost $30 billion, fell 28% in the third quarter alone.

Q: What about global and international funds? Other economies have been slowing significantly, too.

A: They haven't really been much of a safe haven. Basically, the international funds are moving in line with the U.S. stock market, down about 20%. And some regional funds are down even more.

For instance, Japan funds are down almost 30% year-to-date, as are global small-cap funds and European regional funds. Ironically, the riskiest of international investing is in emerging markets, and those funds have lost the least among world equity funds, about 22% this year.

Q: I'd like to know which fund I should put more in -- Invesco Dynamics, Pax World, or Selected American Shares?

A: I can't give investment advice, unfortunately. I would caution you, however, to look at several things: the tenure of the manager, if they've managed money through both bear and bull markets, that manager's track record. And especially the cost of the fund. With returns lower, you have to make at least enough return to pay for the luxury of investing in it.

Q: Any report on how those specific funds rank?

A: Online, we rank funds every month. You can see them on BusinessWeek Online, where you'll get a ranking of risk-adjusted returns.

Q: What about NY Davis Venture Fund (NYVTX)?

A: The fund is a large value fund. It has had a manager on there for about six years. He's a well-known manager. The fund is down about 19% this year, but it has a three-year annualized return of about 11% and that beats the market significantly. It's considered a low-risk fund.

Q: How do the Putnam funds look? Most of my IRA is invested in Putnam Voyager CI-A.

A: Another huge fund! The fund hasn't done well this year because it's a growth fund. The issue here is that they've just changed managers at the end of 2000. So even though they have a long-term track record, it belongs to a manager who has left....

It's too soon to tell whether you should give up on the new managers -- it's a difficult market. The market isn't favoring this fund, but it can be said that this fund has a good long-term track record. It just depends on if the new managers can do what the last managers did.

Q: Mara, in your BW story you summarize in a table some of the things smart managers are doing to ride out the market storm. How about giving us some of the highlights?

A: As I said, managers are looking toward smaller companies and lightening up on big-cap blue chips. They're also tending to favor inexpensive stocks rather than chasing them on account of price momentum. Stocks that are advancing because of earnings momentum are few and far between.

That means thinking longer-term and digging deeper into companies' balance sheets with lots of cash, or which have some kind of proprietary technology or product, and with solid management. Those are the qualities that will propel stock movement once the recovery gets under way. They're also looking at buying more defensive sectors -- health care, finance, and utilities, for example.

Q: We've been talking stock funds -- now what about bond funds, and specifically, are we at risk now to invest in government bonds?

A: There's a lot more volatility, but bonds have really been stellar performers this year. About government bonds, the U.S. government isn't going to go bankrupt. But a public company could, given the uncertainty in the market.

Q: During this period of uncertainty with stocks and most mutuals, is it good to invest in a utility-sector fund?

A: It's a defensive positioning, and it's a diversification issue. They've lost less than general equity funds, so it's worth looking at. There are about 100 of these kinds of funds, and you can find their rankings on BusinessWeek Online.

Here are some top performers: Federated Utility Funds, Strong American Utilities, and Franklin Utility Funds. Those three, year-to-date, have been the best-performing. But any investor would have to dig deeper into the prospectus to see what suits their needs.

Q: How have bear-market and funds that short been performing? It should be a good time for them.

A: And it has been. They're in the winner's circle, and have been all year. They're up as high as 60% year-to-date -- but of course, investors shouldn't be chasing those returns, but using them to hedge against their own portfolios. Investors should put a little bit of money in these funds to hedge long-term.

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