After enjoying spectacular gains last year, mutual-fund investors got a dose of reality in the first quarter of 2004. Renewed concerns about terrorism and economic miscues sent investors fleeing from speculative stocks to more humdrum value stocks. Strangely enough, the often-risky emerging-market stocks also flourished. "The market has two faces," says Rosanne Pane, a mutual-fund strategist at Standard & Poor's (S&P).
It may seem odd that investors want stability at home while they're making dicey bets abroad. But the flight to safety in the U.S. follows last year's big gains in technology, Internet, and other high-flying sectors. "The U.S. market is cycling back to things that are less risky," says Janna Sampson, co-manager of the value-minded $95 million AmSouth Select Equity Fund (ASECX), which gained 2.2% during the quarter through Mar. 26. The average stock fund earned a total return of 1.47%; the average bond fund, 1.54%. (Total return includes appreciation plus reinvestment of dividends and capital gains before taxes.) The best performer during the period was American Heritage, which, despite its name, is a quirky foreign stock fund. It gained 44.44%. The Standard & Poor's 500-stock index lost 0.08%. Fund returns are calculated for BusinessWeek by its sister company, S&P.
While the average fund merely stayed afloat during the quarter, there were some standouts. Among U.S. diversified funds, small-cap value funds performed best, gaining 3.3%. Several sectors, including telecommunications (up 5.38%) and real estate (up 9.15%), also delivered strong performances. Overseas investing fared well: The average diversified emerging- markets fund rose 6.15%, and Japan funds gained a stellar 12.81%.
In fixed-income markets, the biggest surprise came from long-term debt: Bond funds that focus on U.S. Treasuries with maturities of 10 years or more rose 4.2%. The reason: Interest rates continued to fall, confounding many experts who expected rates to spike in early 2004.
Equities managers are hoping strong first-quarter earnings reports will spark better performance for U.S. stocks. "What we have is a very cautious market," says S&P's Pane. "It needs to hear good news on earnings." Profits for small-cap stocks are likely to climb 24.1% in the first quarter, while large-cap profits are expected to rise 17.3%, says Steven DeSanctis, a small-cap strategist at Prudential Equity Group. Small-cap funds are expected to continue to beat large caps because small companies are cheaper and have higher growth rates than blue chips.
Although the U.S. market remains in a wait-and-see mode, mutual funds are enjoying an uptick in popularity. Strategic Insight, a fund consulting firm, estimates that equity and balanced fund inflows during the first quarter will near the prior quarterly inflow record of $134 billion reached in the first quarter of 2000. The influx is a mixed blessing, because managers say it's getting harder to find new ideas. Dodge & Cox Stock Fund (DODGX) closed to new investors in January, after raking in $9.6 billion in 2003.
The problem is even more acute in the small-cap arena: More than 24 small-company funds have closed in the past year, according to S&P. The $1.1 billion RS Partners Fund (RSPFX), for example, nearly doubled since September. To cope with a bigger asset base, portfolio manager Andy Pilara is stretching the fund's small-cap universe from stocks with market capitalizations up to $700 million to those up to $1 billion. Pilara says he wants to avoid becoming a mid-cap fund. "We are considering when to close," he says.
Small-cap veteran Mary Lisanti, manager of the new Adams Harkness Small Cap Growth fund, anticipates at least five more years of outperformance for small companies, mainly because so many stockpickers ignore small caps and underestimate their growth potential. In addition, small caps are outpacing large caps in terms of return on capital. "That's the tipoff to small caps outperforming," Lisanti says. She likes specialty retailers such as AnnTaylor (ANN), which improved inventories and is finally fixing merchandising.
SAFETY IN VALUE
Looking at the broader market, value funds that focus on unloved, conservative stocks are beating funds that invest in high-flying companies with strong earnings growth. A favorite of AmSouth's Sampson is payroll giant Automatic Data Processing (ADP), which has a solid balance sheet and a steady income stream from paycheck processing. Even better, "it's one of the few stocks that will benefit if short-term interest rates rise," Sampson says. Right now, ADP is set to earn about $300 million this year on the tax and payroll payments it parks in the commercial paper market for short periods of time. If rates rise, the company will earn even more, Sampson says.
Among single sectors, real estate funds jumped 9.15% during the quarter, as continued record low interest rates kept the market for new houses and commercial properties afloat. Telecommunications funds, which soared more than 38% in 2003, continued their rebound as well. Timothy O'Brien, manager of the $251 million Evergreen Utility & Telecommunications (EVYBX) Fund, says many telecoms are in better financial shape after shedding debt and cutting expenses. With more fat to trim and enhanced revenue growth, he's bullish on the sector. "You can't save your way to prosperity, but so far, so good," O'Brien says. His top holdings include SBC Communications (SBC), Verizon (VZ), and BellSouth (BLS).
Energy has also caught the eye of fund managers. Energy demand is increasing amid global growth, but supply is shrinking. That's why Larry Babin, manager of the $1.6 billion Victory Diversified fund (SRVEX), is making a bet on the sector with positions in BP (BP) and El Paso (EP). "It's an industry where the major companies have underinvested in the past decade," he says. "There is going to be a lot of catch-up spending." Although exploration and production outfits have had a big run, oil service stocks are just starting to move.
TOPPING THE CHARTS
During the first quarter, investors also found relief overseas, particularly in the emerging markets. S&P doesn't have a category that tracks Eastern Europe, but funds that focus on the region are topping the charts. "The developed markets are coming down, and Eastern Europe is doing fine," says Soeren Rytoft, manager of the Metzler/Payden Eastern European fund, which is up 16.8% in 2004.
High oil and gas prices are helping energy-rich Russia. And natural-resource companies in the region, especially copper and silver producers in Poland, are benefiting from high materials prices. Rytoft sees even better times ahead, with 10 Eastern European countries, including Hungary, Poland, the Czech Republic, and Slovakia, set to join the European Union in May.
Elsewhere in the emerging markets, managers remain bullish on Asia. More than 18% of the $2.2 billion William Blair International Growth fund (WBIGX) is invested in Asian companies. Manager W. George Greig says China is fueling a regional boom, even in once-sluggish Japan. He says Asia should continue to deliver high growth because economies are in good shape, balance sheets are solid, and currencies are well supported. Retailer Esprit, for example, offers "the perfect mix" of Hong Kong sourcing and German merchandising, Greig says.
The emerging markets are also a favorite of fixed-income investors waiting for U.S. interest rates to spike. "It's a game of chicken," says Jan Faller, lead manager of the $425 million Scudder Strategic Income Fund (KSTAX). "Sooner or later, you know rates are going to rise. But one is not rewarded for taking significant interest-rate risk in the U.S." That's why Faller is spreading his risk among emerging-market bonds that don't correlate as closely with the U.S. debt market. "We view the emerging markets as a place to hide for now," Faller says. The fund holds sovereign bonds from Russia, Romania, Bulgaria, and Brazil.
While U.S. junk bonds don't offer huge returns relative to U.S. Treasuries, fund managers think they are a decent play. "As the economy improves, default rates should go down," says Richard T. Whitney, manager of the $2.1 billion T. Rowe Price Balanced Fund (RPBAX), which has 8% of its portfolio in high-yield bonds. Junk bond prices are less vulnerable to rising rates because in a good economy, the issuers' finances are improving and they become better creditors. In a market that's moving in disparate directions, adding a little junk to your holdings is not a bad strategy. By Lauren Young