For the past three years, making big money in mutual funds wasn't much harder than shooting fish in a barrel. From 1995 through 1997, U.S. diversified funds earned an average annual return of 24.5%. That's a rate that doubles your money in just three years. For investors, it doesn't get much better.
But now it seems increasingly likely that the stock market will not continue to deliver such extraordinary returns in coming years. The bull has lost some of its vigor. While most stocks are down from their highs, they are no longer cheap, and the earnings engine that powered the long drive is slowing.
More worrisome, the market has become riskier. Wall Street has become so skittish that events on the other side of the globe that would not have made the evening news ten years ago now trigger violent market moves. On Jan. 9, as Indonesians dumped rupiahs and hoarded food, the Dow Jones industrial average took a 222-point nosedive, ending one of the market's worst weeks in years. True, the U.S. economy is perhaps in the best shape in more than a generation. But the financial markets are so intertwined that troubled economies and sinking stock markets around the world are sure to give investors occasional twinges of pain.
BUSINESS WEEK's annual Mutual Fund Scoreboard is just the prescription to get you through these manic markets. Our fund ratings, prepared by Morningstar Inc., don't just look at what funds scored the highest returns. It's our belief--and it has been since we launched the Scoreboard in 1986--that the best funds are those that deliver the most return for the amount of risk they take with your money. We adjust those returns for the fund's downside volatility. The funds with the highest risk-adjusted returns make the A-list. We don't rush to judgment, either. To even get a BW rating, we insist on a five-year history, time enough to analyze performance under a variety of market conditions. (We rate bond funds in next week's issue, and closed-end funds the week after that.)
The 86 equity funds (out of a total of 1152 with enough history to be rated) that made the A-list are not the kinds of funds you usually see at the top of the annual fund-performance derby. The American Heritage Fund, up 75% in 1997, the best-performing fund in absolute numbers, is rated by BW as a big, fat F. It was one of the worst performers in 1994 and 1995, and even with last year's stellar showing, the five-year average annual return is a little more than 1%.
The investor doesn't give up much in the way of return when he or she invests in the best risk-adjusted funds. Over the last five years, the average annual return for the funds on the A-list is 19.3%. True, that's 0.9 percentage points less than the Standard & Poor's 500-stock index, but all but four of these funds have "low" or "very low" risk when compared to the index. "When you look at funds by risk-adjusted returns, you are not necessarily looking at the most profitable funds, but the most comfortable funds," says Don Phillips, president of Morningstar. "Most of these funds can be considered all-weather investments."
They're the sorts of funds that can guide your money safely through rough waters. "We don't perform as well on days the market goes up," says David J. Williams, portfolio manager for the Excelsior Value and Restructuring Fund. "But we hold like a rock when the market is down." And they're run by cool-headed managers who see market gyrations as opportunity. "Choppy markets are good for us," says Mutual Series' Michael F. Price. "That's when we find things to buy." Just last week, Price dispatched a member of his team to Asia to hunt for bargains.
PLENTY OF GEMS. And the A-list gives you a wide variety of choices to meet differing investment goals. It ranges from Fidelity Select Home Finance, a high-flying financial fund with a 32% average annual total return for the last five years, to the Merger Fund, with a 12.1% return, and Fidelity Asset Manager: Income, with just 10%. Some of the names are familiar: Dreyfus, Fidelity, Franklin, Putnam, T. Rowe Price, and Vanguard. But there are plenty of gems from fund families not so well known, such as Excelsior, Flag Investors, Longleaf, Vontobel, and Westwood.
What you won't find on the main A-list right now, nor have you for the past several years, are international funds or the higher-volatility domestic sorts, such as small-cap growth funds. These funds are riskier than average, and to make the A-list they need to have had much higher returns. Yet even before the latest crises in Asia, international markets have significantly lagged behind the U.S. for the last three years; small-cap growth stocks in general have been pummeled over the past 18 months. Yet these are important and sometimes profitable areas of investment and should not be ignored.
So using the same ratings system, the Scoreboard also includes category ratings---how funds rate when compared with their peers. Looking for a well-rated foreign fund? Try BT Investment International Equity Fund, with a 19.1% average annual return over the past five years. Need a small-cap growth fund to round out a portfolio? Take a look at Baron Asset Fund, with a 24% average annual return, a real winner. It carries a B+ rating when compared to all equity funds, while the other two A-rated small-cap growth funds, Managers Special Equity and SmallCap World, only come up with a C, just average, in the all-fund ratings.
You'll find all the fund ratings in the BW Scoreboard. But ratings are just a starting point. We examine fund performance, both before and after taxes; note fees in acquiring and expenses of owning funds; take a look at what's inside the funds' portfolios; and examine each fund's behavior. If a fund has a rating, we can also tell you its level of risk, from very high to very low. Performance can rise and fall with markets, but a fund's risk level does not vary nearly as much as returns and is far more predictable.
Another feature, which looks at a fund's best and worst quarters of the past five years, is yet another way to view risk and volatility. For instance, the AIM Aggressive Growth and Sequoia Funds have earned an average annual return over the past five years of 23%, and for both, the best quarterly return of that period was 21%. But the worst quarterly performance for AIM was -13.9%, while Sequoia's worst hit was -2.1%. Which fund would you rather own? (Well, you can't actually own Sequoia because it's closed to new investors.) In all, the Scoreboard that begins on page 90 provides data on 885 non-institutional funds that were in operation for at least one full year and have more than $170 million in assets.
Want data on more funds? Go to Business Week Online (www.businessweek.com). There you'll find an interactive Scoreboard with those 885 funds plus another 1,400. With simple-to-use features, you can look up funds by name, or use some of the handy pull-down menus to find, say, the best- or worst-performing funds for various periods, or zoom in on specific categories of funds. Best yet, the online Scoreboard will be updated each month, giving you an exceptional tool for keeping up with your funds' returns and the BW ratings throughout the year.
In the three months since the Asian woes became Wall Street's worry, U.S. mutual-fund shareholders have been doing exactly what they've been doing for years--pouring billions of dollars a month into funds. "The commitment to equity investment has persisted," says Avi Nachmany of Strategic Insight Inc., a mutual-fund consulting firm. Indeed, while net cash flow to funds dropped to $6 billion in November, estimated inflows for December are $18 billion, about 50% higher than December, 1996. For all of 1997, cash inflow is estimated at over $230 billion. Robert Adler, whose AMG Data Services tracks fund flows, isn't quite so sanguine and believes heightened market risk is prompting investors to hold back. "January will be nowhere near as big as last year, [when $29 billion poured in]" says Adler.
Where investors have shifted course is in moving away from the more targeted regional funds, such as those specializing in Asia funds, to more broadly diversified international funds. That's hardly surprising: The investment returns in those funds last year were horrid. Japanese funds, down 16.8%, were the best performers in Asia. The somewhat better--or less bad--performance from the Japanese market allowed the diversified Pacific category of funds, down 29%, to beat the Pacific funds that exclude Japan, which were down 33.9%. The only worse investment than owning Asian funds last year was owning precious metals funds, down 42%. Even the turmoil in Asia did not spark demand for gold (table, bottom, page 78).
Bad as those numbers are, mutual- fund investors as a whole have not lost much money. There has never been all that much in those hard-hit funds in the first place. International equity funds make up about 15% of all equity- fund assets; diversified emerging-market funds comprise only 7% of that 15%, or 1.1% of the total. Southeast Asian or Japanese funds are even thinner slices of the mutual-fund pie.
In the final analysis, investors dabble with funds from the investment fringe, but they put the bulk of their money in big, mainstream funds (table, top, page 78). Six of the 20 largest sport A ratings for overall performance. That shouldn't be too surprising, since performance is what builds assets and draws in new cash.
One of these is Fidelity Growth & Income. Of the fund giant's equity funds, only Fidelity Magellan is larger, but it is now closed to new retail investors. (It's still open to retirement plans.) To keep risk under control, Fidelity Growth & Income's Steven Kaye balances the fund with both value and growth stocks, and downplays high technology. "I don't like the idea of an investment disappearing overnight," says Kaye. "I like getting a good night's sleep." The Asian troubles, he says, might shave corporate profits some, but that damage should be offset by lower interest rates. His biggest bet now is health care: "The fundamentals are great, and I don't have to worry about the economy."
The fund most likely to knock Magellan off its perch as the largest mutual fund is Vanguard Index 500. It's by far the largest of the index mutual funds, and indexing--investing in a portfolio that tracks a popular market index such as the Standard & Poor's 500--remains a popular and so far profitable strategy. For each of the past four years, the index funds beat the returns on the stock-pickers' funds. No doubt, that's why index funds pulled in about one in every eight dollars that went to funds last year. That's roughly $30 billion, and it's up from $22 billion in 1996 and $10 billion in 1995. Still, that leaves plenty of money for the actively managed funds.
DIVIDEND PLAYS. Without a broad-based upward sweep in the index, good stock-pickers should be better able to show their stuff. And 1998 could be the year that the active stock-pickers prevail over the passive indexers as they did in the 1991-93 period. The BW Scoreboard helps you identify some talented fund managers by looking at the top-rated funds. Consider William J. Stromberg, who runs T. Rowe Price Dividend Growth Fund.
Dividends? With payouts so low, how can buying dividend-paying stocks be a profitable strategy? "Our philosophy is to invest in companies with a regular pattern of raising their dividends," says Stromberg. "The only way companies can do that is to keep increasing their earnings and their cash flow." In a period of high capital gains and low interest rates, investors have shown scant interest in dividends. But in an environment where capital gains are harder to come by, those dividend-growers could be even more valuable.
If selecting stocks by dividend growth rates sounds a little odd, what about investing in companies based on the state in which they're headquartered? Of course, if the state is California, you've got 1,400 public companies and a $1 trillion economy that's just slightly less than that of Great Britain.
Conrad Herrmann, portfolio manager of the Franklin California Growth Fund, and his team of analysts are based in San Mateo, a short drive from Silicon Valley, home of some of the world's most dynamic companies. "When you drive by the headquarters on a Sunday afternoon and the parking lot's filled, it's a clue something is up," jokes Herrmann. "But what you don't know is whether it's good or bad." While the state's heavy technology presence gives the fund a bias toward higher growth, higher-risk companies, Herrmann balances that by diversifying in leading companies of more mundane industries such as energy, banking, and real estate.
The A-list funds show there is more than one way to pick stocks and deliver exceptional returns. Excelsior Value and Restructuring Fund's Williams built a top-drawer record by assembling a portfolio of companies undergoing consolidations, selling assets, and refocusing their businesses. Restructuring, he says, is not a fad but is now part of corporate life. "Companies can no longer raise prices to raise profits," says Williams. "They have to run more efficiently."
HEFTY PROFITS. Susan M. Byrne, who runs the A-rated Westwood Equity and Westwood Balanced Funds, takes a different tack. She looks for companies whose positive earnings surprises draw no reaction from investors. "That tells you the Street thinks the good news is a fluke, or nobody's paying attention," says Byrne. Working with those stocks, she makes her own assessments of the companies. One of her biggest hits: Dell Computer Corp., which she bought at a split-adjusted price of 4, selling the last shares at 76 for some hefty profits. Says Byrne: "If I'm right, I make a lot of money. If I'm wrong, the stock doesn't move. All I've lost is opportunity cost." The only difference between her two funds: The equity fund is all stock, while the balanced mixes the same stocks with bonds.
Top-rated Flag Investors Value Builder also blends stocks and bonds and chooses each with aplomb. "We'll go anyplace to invest our money if we can understand the company and how we can make money on it," says portfolio manager Hobart C. Buppert, who launched the fund in 1992. "I don't know of any value fund that would have Ford Motor and America Online, but I thought we could make money on both." His largest equity holding, though, is insurer Conseco. The company, he says, is growing faster than most in the industry but sells at a lower price-earnings ratio.
On the bond side, Buppert doesn't take the easy route of stuffing the portfolio with U.S. Treasuries. He buys corporate bonds and puts them through the same company analysis he gives stocks. "I stick with intermediate-term bonds," he adds. "If you're buying 20-year bonds, the risks are so great you might as well own stocks." The average annual return over the last five years is 17.7%, far surpassing the 12.9% average annual return for the domestic hybrid fund category.
Those are just a sampling of the many fine funds that emerge from BUSINESS WEEK's fund analysis. You can find a wealth of data on them and a whole lot more, starting on page 90--and at Business Week Online.