Mutual Funds: The Bears Have It

Last quarter's double-digit gains belonged only to those who bet on market declines

Aaarugh! That about sums up the third-quarter performance--or lack thereof--for equity mutual funds. Or for most funds of any kind. With U.S. diversified equity funds plunging an average of 14.8%, vs. the 9.5% tumble of the Standard & Poor's 500-stock index, U.S. diversified equity funds are on track to rack up their fifth year of underperformance against the broad index. Among equity funds, not one category tracked by Morningstar Inc. managed to eke out a positive return as of Sept. 21. To get even more of a feel for how depressing a quarter it was, consider this underwhelming victory: The very best-performing equity fund group, utilities, sported a -4.2% total return. "It was the quarter that put the fear of God back into investors," says Kurt Brouwer of investment advisory firm Brouwer & Janachowski. "It reminded people that risk exists."

The few funds that managed to achieve double-digit gains were, not surprisingly, designed to profit from a bear market. After being down 6% for the quarter before July 17, when the stock market peaked, Prudent Bear fund manager David Tice has since seen his fund roar back, racking up an 18.4% gain for the quarter. Tice and other bearish fund managers have waited a long time for such a triumph. Says Charles L. Minter, portfolio manager of two other bear funds, Comstock Partners Capital Value A fund, which gained 14.8%, and Comstock Partners Strategy O, up 11.5%: "A lot of people would have thrown in the towel by now, but we haven't, and we think history will prove us right." Minter's tenacity has been costly: At the end of 1990, the Comstock Partners Strategy O Fund had $1.2 billion in assets. It now has about $90 million.

"RISK DIDN'T PAY." The bears managed to snag 6 of the top 10 slots among the best-performing mutual funds for the quarter and garnered virtually all of the double-digit returns. ProFund Advisors LLC's $49 million UltraBear ProFund, which seeks to produce a return of twice the inverse of the S&P--to be up, say, 10% on a day when the S&P is down 5%--saw its strategy rack up a 17.4% gain, hitting its target. The fund has 90% of its assets in money-market instruments and 10% in exchange-traded futures and options contracts that are bets on a declining market. ProFund, geared toward investors who want to profit from short-term movements in the market, allows shareholders unlimited switching among a family that includes the Bear, Ultra OTC, UltraBull, and Bull ProFund. Right now, ProFund has a lot of people on the sidelines, with $60 million in the firm's money market funds.

Equity funds taking a more balanced approach avoided much of the downdraft. Of the top 50 performers, 14 were income-oriented utility funds, which shone in a falling-rate environment. A number of "lifestyle" funds, which invest in a mix of stocks, bonds, and cash, also showed up in the top 50. While their returns won't enhance anyone's lifestyle--the five such funds on the list of winners were down an average of 0.35%--they won't crimp it either, and in the third quarter, that was something to be thankful for. Sums up John Rekenthaler, director of research at Morningstar: "It's the worst quarter for stock funds, across the board, since the third quarter of 1990."

The carnage caused many investors to flee from risky securities and seek quality. "The big theme for the quarter is that risk didn't pay," notes Rekenthaler. "Really high-risk securities like emerging-market and high-yield debt, or small-cap stocks, got annihilated. Medium-risk securities, such as better-quality blue-chip stocks, just got whipped." The exception to the trend: high-quality securities such as Treasuries. Indeed, the highest return came from long-term government funds, which rose 4.9%.

Other investors sought shelter in traditional defensive issues, such as utilities or precious metals. That helped investors beat the S&P's 9.5% loss. But are losses of 4.2% and 7.8%, respectively, much to cheer about? Another diversification play, supposedly with a defensive bent, would be real estate funds. But they underperformed the S&P and were about even with the decline in the average U.S. diversified equity fund, losing 14.3%.

HAMMERED. Size didn't matter this quarter, as large-cap, mid-cap, and small-cap funds posted average losses topping 10%. Losses were large among the industry's biggest mutual funds (table), too, though 7 of the 10 largest funds did manage to have smaller losses than the S&P. Fidelity Magellan is still the largest fund, at $62.3 billion, but it lost 10.2%. The best-performing megafunds: Vanguard/Wellington, which had a 4.6% loss, and Fidelity Puritan, down 6.7%. Throughout the long bull market, these funds tended to trail their bigger, more equity-oriented brethren, since they are hybrids and invest in bonds. But in this environment, their bond holdings helped limit the damage.

Bond funds were hammered far less than equity funds, but even they didn't escape the bloodbath. The average return of 1,285 taxable bond funds tracked by Morningstar: -0.65%. While many bond funds ground out gains of 1% or 2%, a few lower-rated bond groups had major meltdowns. High-yield bond funds slid 8.5%, and emerging-markets bond funds plunged 32.5%. That burned a lot of investors, since up until April about 80% of the money coming into bond funds was in emerging-market debt, according to David C. Masters, senior fund analyst at Standard & Poor's Micropal. Brouwer calls the stampede out of emerging markets a triumph of perception over reality. "Latin America is doing pretty well, but once the dam burst in Russia, everyone started dumping everything," he says. "These countries are priced as though they're going away. There's definitely value in Latin America."

FEELING GOOD. Some bond-fund managers bucked the downward trend. One manager feeling good is David W. Schroeder, who counts three funds he either manages directly or oversees among the quarter's top 10 performers. He had the top-performing bond fund for the quarter: the $154 million American Century-Benham International Bond Fund, up 9.7%. One big reason for the gain: the flight to quality. The fund focuses on high-quality bonds--bonds rated AA or higher--and 65% of fund assets must be invested in government or agency securities. Schroeder describes the fund as "a fairly diversified, high-quality currency play" aimed at preserving dollar purchasing power when the dollar is falling against G-7 currencies such as the Japanese yen and German mark. Schroeder, whose fund is 80% invested in European currencies, figures about 6.7% of its gain came from its currency play this quarter. Schroeder's other winners are two zero-coupon Treasury bond funds.

While the U.S. equity market caused a lot of investors pain, venturing into the equity markets of less developed countries proved excruciating. The biggest loser: the $20 million Lexington Troika Russia Fund, down 64.1%. The best-performing equity market in 1997, Russia has become 1998's worst-performing market because of a political and economic collapse, says Lawrence Kantor, managing director of Lexington Management Corp. Kantor isn't giving up on Russia and is positioning his fund to pounce on a recovery once the uncertainty ends. The fund is now about 30% in Russian oil, telecom, and utility companies that Kantor says have good cash flow, with the balance in U.S. Treasuries.

The turmoil in Russia spilled over into the emerging markets, and the damage there is severe. Latin American equity funds fell more than 33%, and diversified emerging-markets funds fell 26%. Of the 10 worst-performing funds in the three months ending Sept. 21, seven were focused or heavily invested in Latin America. Sticking to more-developed equity markets didn't help much, with Europe funds falling an average of 19.6%.

So far, despite the market's violent behavior, investors aren't stampeding out of mutual funds. About $5.4 billion flowed out of funds in August, says Carl Wittnebert, director of research for Trim Tabs Financial Services Inc. But he estimates that equity funds could see a $20 billion inflow in September, an average monthly rate for 1998. "We think people are now putting money in money-market funds that earlier would have gone in equity funds. People get scared, and wait for the market to stabilize and go up." That may mean steeling themselves for at least a few more quarters of pain.

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