For investors, 1996's third quarter is sure to be remembered as one of the most schizophrenic periods in years. Early in the quarter, the Dow Jones industrial average plunged nearly 400 points in a few weeks' time, a move proclaimed by many market gurus to be the final curtain on the six-year-old bull market. But the market came roaring back, and the Dow and the Standard & Poor's 500-stock index have broken through old highs. With corporate earnings strong and interest rates steady, the market seems poised for further gains.
Mutual-fund investors have taken that same wild ride. But on average, their investments still have not come back as strongly as the Dow and the S&P. For the third quarter (through Sept. 23), equity-fund investors made little money. The average return for all-equity funds comes to a scant 0.80% (appreciation plus reinvestment of dividends and capital gains before taxes), vs. 2.89% for the S&P 500. Negative returns from overseas funds kept the average down. Diversified funds investing in the U.S. fared better, eking out a 1.61% return. Year to date, all-equity funds are up 10.64%, vs. 13.2% for the S&P 500 and 12.5% for U.S. diversified funds. Returns are calculated by Morningstar Inc.
The bond market jumped nervously during the quarter as well, with the yields on long-term government bonds swinging between 6.74% and 7.15%. Yet bond funds held up reasonably well considering a market in which sentiment seemed to change hourly. Taxable funds--U.S. government, corporate, and international funds--earned total returns of 1.48%. Tax-free municipal funds fared nearly as well, up 1.20%.
But nowadays, all eyes are on equity funds. That's where most investors are channeling their money. In the first eight months of 1996, investors plunked $160 billion into funds that buy stocks, according to the Investment Company Institute. In contrast, the net cash flow to bond funds has been a paltry $8.1 billion.
NO APPETITE. The summer sell-off scared some equity-fund investors, and July's net cash flow, $6.2 billion, was the lowest figure in 17 months. Those scary few weeks also made fund investors more cautious, says Robert Adler of AMG Data Services, an Arcata (Calif.) firm that tracks mutual-fund cash flows. In the first half of 1996, says Adler, nearly two-thirds of the equity cash flows went to the most aggressive growth funds. Since then, about half the cash is going to the more conservative portfolios, like growth-and-income funds.
In part, that explains why the blue-chip indexes climbed to new highs in September. And it also explains why the NASDAQ Over the Counter Composite and the Russell 2000--the indexes that better reflect the more aggressive equity funds--did not. Until investors regain their appetite for riskier funds, it's going to be tough for smaller companies and the funds that invest in them to regain their lead. The quarter's results bear this out. The growth-and-income funds earned a total return of 2.59%, vs. 0.05% for the maximum-growth funds and -0.03% for small-company funds.
The summer rout also pushed some former highfliers onto the quarter's list of worst performers. Among them are Dreyfus Aggressive, Rockwood Growth, and two Van Wagoner funds, Emerging Growth and Micro-Cap. Still, those funds have strong returns year-to-date.
Among the more specialized funds, financial funds sparkled. One big reason, notes James K. Schmidt, portfolio manager for John Hancock Regional Bank B Fund, up 8.66%, was better-than-expected earnings from banks. The other: NationsBank's $9.8 billion offer for Boatmen's Bancshares reminded investors that there's money to be made from the industry's consolidation. "We've gone from 14,000 to 9,800 banks since I started this fund 11 years ago," says Schmidt, "but I believe we're heading for 4,000. We have a long way to go."
Funds specializing in real estate investment trusts (REITs) also blossomed in the third quarter, posting on average returns of 4.91%. Many investment advisers have long recommended these funds, not because of their barn-burning returns but because they have little correlation with the stock market in general and thus add diversification to a portfolio of funds. AMG's Adler says weekly inflows to REIT funds tripled during the quarter, to a record $75 million. Still, there are solid fundamentals behind those REITs. "Rents are rising, cash flow from properties is increasing, and that gives REITs the ability to raise dividends," says G. Kenneth Heebner, portfolio manager of CGM Realty Fund, up 6.98% during the quarter.
The wild market swings made it difficult for the largest equity funds (table). Only Vanguard/ Windsor and Washington Mutual Investors beat the S&P. The giant Fidelity Magellan Fund, under the direction of a new manager, Robert E. Stansky, gained just 1.22%. Stansky has trimmed Magellan's controversial Treasury bond holdings but has made only minor changes to the stocks. Magellan has also suffered outflows, with assets down $4.5 billion in the past four months.
BATTERED BARGAINS. Some of the very smallest funds, funds recently launched, actually benefited from the early-summer scare. "We were fortunate to have opened during the sell-off," admits Blaine P. Collins, portfolio manager of Janus Equity-Income Fund, up 14.2%, the second-best performance for the quarter. He bought blue chips such as Campbell's Soup, Wells Fargo, and EDS "at panic levels and got 10%-to-15% pops from them." Portfolio manager John C. Bogle Jr. also took advantage of the sell-off to load up his new funds, NI Growth, up 7.41%, and NI Microcap, up 6.36%. He bought battered stocks in the technology, health-care, and specialty retail sectors--and still finds bargains in those areas.
Stock-picking is what really mattered in the third quarter. Note that many kinds of funds appear on the best and worst list for the third-quarter (previous pages). For instance, each table contains small-company, growth, technology, and precious-metals funds. "It's stock selection, not sector-picking, that's paying off," says Jeffrey M. Mortimer, vice-president at Higgins Associates, a Cambridge (Mass.) firm that manages funds of funds for institutional investors.
IN THE DETAILS. Consider EV Marathon Gold & Natural Resources, with a 19.43% total return, the quarter's best performer, far surpassing both the average natural-resource and precious-metals funds. The secret, says manager Barclay Tittmann, is investing in smaller resource-exploration companies that are making discoveries and adding to reserves rather than large companies "dependent on the price of a commodity."
The picky nature of this year's market is also playing into the hands of picky investors. Robert M. Gintel, who buys beat-up companies that he believes will bounce back, is riding high. The $110 million Gintel Fund is up 9.09% for the quarter and 27% year-to-date, and the $31 million Gintel ERISA Fund, which will soon merge into the Gintel Fund, is up 8.38% and 22%, respectively. "Situations we've owned for a long time--and suffered with for a long time--are finally coming to fruition," he says. Among his winners: Chart Industries, Capstead Mortgage, and Checkfree.
William H. Miller, portfolio manager for Legg Mason Value Trust, is also on a roll, up 8.14% for the quarter and 20.1% year-to-date. One big winner this year is Dell Computer Corp., which he bought at 28 in February when investors were trashing computer stocks. It's up 140% since, and he still holds it. He's also a bull on Citicorp. "Citi's earnings should grow as fast as Merck's over the next five years, yet its [price-earnings ratio] is far lower," he says. The stocks in his portfolio sell at a cheap nine times next year's earnings.
Portfolio manager Derek H. Webb, who runs GT Global Consumer Products & Services Fund B, thinks larger growth stocks offer great value. "I don't mind paying 20 times earnings for Nike," says Webb, "because it's growing twice as fast as Coke, which has a p-e of 32." The fund is the third-best this quarter, up 11.83%, and is up 42.4% for the year.
The best-performing bond funds, generally those that invest in emerging-markets debt, have also scored double-digit returns. Such funds suffered huge losses several years ago, when the Mexican peso crisis precipitated a collapse in prices of most Third World debt. Now, the Mexican government is buying back debt in the markets, says John Carlson, who runs Fidelity New Markets Income and Fidelity Advisor Emerging Markets Income T, up 10.16% and 10.37%, respectively, for the quarter. Carlson expects the rally to run into the fourth as other developing nations continue to buy back their debt.
In contrast with the fat numbers posted by some taxable bond funds, the best municipal funds look scrawny. The top performer for the quarter is the Strong High-Yield Municipal Bond, with a 2.46% total return. But muni funds lure investors mainly with their yields. In that light, Strong High Yield looks better. Its annualized 6.89% tax-free yield is the equivalent of 10% for investors in the 31% federal tax bracket. That's enough to make some die-hard equity-fund investors think about munis.