For the past two years, making money in mutual funds seemed no harder than writing a check. But 1997 is unfolding as a different story. Interest rates are pushing higher, small-cap stocks are heading lower, and prices for high-tech stocks are in a near-meltdown. As a result, fund returns earned so far this year are barely in the black. The total return for the average equity mutual fund is just 1.1%, vs. 7.1% for the Standard & Poor's 500-stock index (through Mar. 24). Fund returns are prepared for BUSINESS WEEK by Morningstar Inc.
But behind those averages are some wide divergences in performance. Most funds that invest in large-cap stocks are still faring well. That's because investors have been increasingly flocking to large-company stocks like those in the S&P 500, or buying index funds outright. The Vanguard Index 500 Portfolio, which replicates the S&P 500, is now the second-largest equity mutual fund and is taking in cash at a rate of over $200 million a week. As more investors buy S&P 500 funds, more money is spent on those same 500 stocks, and the harder it becomes to beat the index. All but two of the 10 largest equity funds are trailing the S&P 500 index (table).
Returns drop off quickly for funds that invest in mid-cap and small-cap stocks. Worst of all are the results from the small-cap growth funds. They're down over 9%, even worse than the returns from the Japanese funds, which are suffering from a sinking yen in addition to sagging stock prices. Even pure technology funds posted better returns, down 6.9%, because on average they own much larger companies than the small-cap growth funds.
The poorest-performing funds for the first quarter include a host of well-known small-cap growth funds that soared in years past: PBHG Emerging Growth, American Century-20th Century Giftrust, and PIMCo Opportunity C funds. The three are down over 19% each (table). "We buy the companies with the highest absolute growth rates, and when the market gets apprehensive, these are the stocks that get pounded the most," says Gary L. Pilgrim, chief investment officer for the PBHG funds. "But over time, we've found the returns make it worthwhile to live through the volatility." So don't expect the managers of these beaten-down funds to start investing any differently. "The worst thing to do is to change the character of your fund," says Glenn Fogle, lead manager of Giftrust.
SKIN CREAM. Ironically, the quarter's best-performing fund, American Heritage Fund, is classified by Morningstar as a small-cap growth fund, but it's in a class all by itself. A onetime high-flier, the fund had $150 million in assets in 1993. Then it plunged in 1994, and by the end of 1996, the fund's net asset value (NAV) was down 57%. Investors redeemed in droves during those years, which contributed to the losses. Portfolio manager Heiko H. Thieme says he unloaded many winners such as IBM and Philip Morris to meet redemptions, leaving large, illiquid positions in obscure companies. One such holding, the British biotech firm Senetek PLC, now comprises half the fund's $20 million in assets. The stock's nearly tripled this year, and it's the reason for the fund's rebound. The firm makes beauty creams for aging skin, and its male impotence drug is currently in trials in Great Britain.
Still, American Heritage Fund is more of a fluke than a harbinger of better times for small-cap growth funds. This year's fund returns are a continuation of trends that began in the middle of 1996. That's when small-cap stocks peaked and lost their leadership position in the bull market. After the market swooned in early summer, the blue-chips came back like gangbusters while small-caps and mid-caps struggled and many ultimately sank. Since mutual funds, on average, invest in smaller companies than are in the S&P 500, their results have lagged as well.
The performance pattern in international equity and bond funds is a carryover from 1996 as well. Diversified emerging markets funds are beating the more mainstream foreign funds. Likewise, emerging markets bond funds are far ahead of general international bond funds. They're leading domestic convertible and high-yield bond funds as well. Both taxable and tax-free funds had a break-even quarter, with interest income offsetting declines in NAV caused by rising rates.
For most investors, the first quarter's returns are more disappointing than disastrous. There's nothing yet to suggest the public has lost its appetite for funds. In the first two months of 1997, equity funds netted some $50 billion, a pace that, if kept up through the year, would certainly set a new record. But Robert Adler of AMG Data Services Inc. says the pace is slowing. He says equity funds only took in about $6 billion in the first two weeks of March, and investors are, on balance, pulling out of the aggressive small-company funds.
Sure, savvy investors should be able to earn more. But how? Riding the crest of the index boom? That's what they're doing at Flex-funds Muirfield Fund, which has 80% of its assets in an S&P index fund. "Our discipline tells us to go with the funds that are performing best," says Robert S. Meeder Jr., the portfolio manager. Bottom-fishing among the bludgeoned small-cap growth funds? That's an interesting contrarian bet, but there are few signs that the bear market for these funds is over.
Since growth stocks are on the ropes, many fund strategists see the best opportunities in "value" funds. These funds buy stocks with price-to-earnings ratios and price-to-book value ratios that are below the market average. Some of the best performers for the quarter are from the value camp--the Oakmark Funds managed by Chicago-based Harris Associates. The Oakmark Select Fund, launched Nov. 1, is up 25% since inception and 12% so far this year.
BIGGER BITE. Portfolio manager William Nygren invests in just 20 stocks, with half the assets in the five-largest holdings. The newcomer has scored big with takeovers, First USA and McDonnell Douglas. Such concentration has risks: An investment gone bad will take a bigger bite out of the portfolio. Because it invests in smaller companies, sister fund Oakmark Small Cap spreads its money over 50 stocks. That fund is up 8.2% this year on top of last year's 39.8%. Oakmark's management says it will consider closing the fund, now with $648 million in assets, when it reaches $750 million.
To liven up their portfolios, investors might look to the emerging markets, especially to Latin America, Eastern Europe, and Africa. The Latin funds, the only fund category to earn double-digit returns in the first quarter, are on a roll that began last year. Now, the whole region is picking up momentum. "People who were reluctant to invest because of the Mexican crisis of 1995 saw last year's performance and are coming back," says Paul H. Rogers, a manager at the Scudder Latin America Fund. Most of all, investors are back for the right reasons. "Economic growth has returned, and is accelerating while inflation is coming down," adds Alex de Bethmann, portfolio manager of the Federated Latin American Growth Fund.
Investors are finding opportunities even in Africa, the world's poorest continent. One big winner is Egypt, where the stock market is up about 50% in the last three months. "Inflation is coming down, GDP growth is over 4%, and the government is starting to privatize business," says Clifford D. Mpare, portfolio manager of the Calvert New Africa Fund, up over 15.6% this year. About half the fund is invested in South Africa, which is rebounding after a poor 1996. Industrial stocks are up about 12%, and the rand is one of the few currencies appreciating against the dollar.
U.S. investors shouldn't have to depend on exotic markets to make money this year. Even with a less-than-notable first quarter, many still forecast good returns for 1997. "I'm not running for cover," says Eric Kobren, a fund analyst who just launched the Kobren Insight Funds, a series of three funds-of-funds. "It's just that people got used to earning 20% or 30% annual returns with no risk, and that's not going to happen this year." Adds Robert J. Markman of Markman MultiFunds: "We'll alternate months of euphoria and months of despair, and a year from now, the market will be up between 6% and 12%."