For the second year in a row, the third quarter has turned out to be one ugly stretch for mutual fund investors. The Standard & Poor's 500-stock index peaked in mid-July and the Dow Jones industrials in August, and it has been downhill since. Bond prices have been sinking, as has the dollar. For the quarter through Sept. 27, the average U.S. diversified equity fund showed a negative total return: -5.58%, vs. -6.31% for the S&P 500. Equity funds as a whole fared a little better, falling just 3.69%.
S&P 500 index funds, so popular and rewarding for so long, were no place to be in the past few months. Of the 27 categories of equity funds tracked by Morningstar Inc., all but seven beat the S&P (table, page 156). Value funds, which came to the fore early in the second quarter, fell behind again, thanks in large part to sinking financial stocks. Banks, brokers, and insurance companies fell victim to higher interest rates, earnings shortfalls, and a slowdown in mergers and acquisitions. That gave financial funds the quarter's worst performance. "Financial stocks are awfully attractive relative to the rest of the market," says Jeffrey Morris, portfolio manager of Invesco Financial Services' fund, down 16.59% for the quarter. "But I just don't know what the catalyst will be to get them moving again."
"BAD QUARTER." Losses in financial stocks wreaked havoc on Vanguard Windsor II, down 13.86%, and made it the worst-performing of the Big 10 equity funds (table, page 154). Another factor likely stemmed from the 64% decline in Waste Management Inc., one of the fund's ten largest holdings at the start of the quarter, says Dan Wiener, editor of The Independent Adviser for Vanguard Investors. "There's been no sea change in the way the fund is managed," says Wiener. "It's just been a bad quarter." All told, six of the megafunds beat the S&P, including Vanguard 500 Index, which inched out its benchmark by a few basis points.
The volatile market and souring fund performance are taking their toll on investors, who are slowing contributions and stepping up redemptions. Industrywide, cash inflows for the January-through-August period are down 18.5% from last year and 31% from the record set in 1997. Robert L. Adler of AMG Data Services, which tracks cash flows into funds, says in five of the past 12 weeks more cash came out of equity funds than went in.
About half of the cash inflow went to technology and large-cap, mainly S&P 500, index funds. Tech funds are still on a roll, up 7.85%, and in fact they picked up momentum toward the end of the quarter even while the overall market went downhill thanks to Net stocks. But Adler worries about index funds. Actively managed funds now have 4.8% of assets in cash, but indexers have none. So if redemptions someday outpace inflows, the funds have no choice but to sell stocks. Says Adler: "In a declining market, that would be like throwing gasoline on a fire."
Bond funds offered some refuge, but investors would have been better served by a money-market fund. Taxable bond funds had slightly negative total returns for the quarter, -0.04%, with the best showing coming from short- and ultrashort-term funds. International bond funds that don't hedge their foreign currency exposure also benefited as the yen and euro gained against the dollar. But tax-free bond funds performed even worse than taxables, down 1.26%.
GLITTERING GOLD. If anything, the quarter's results reinforced the principle of diversification among fund categories. Just look at the precious-metals funds, an all-but-forgotten investment for most of the past five years as deflation and central bank bullion sales hammered their price down. On Aug. 25, gold traded at $252.55 an ounce, the lowest price in two decades and just slightly above the average cost of production.
But in late September, 15 central banks said they would not sell gold over the next five years beyond the 2000 tons already scheduled to be sold. That removed fears of additional supply. Bullion prices jumped 20%, to $308 in two days, but gold-mining stocks jumped 40%. That made gold funds the big winners for the quarter, but not necessarily a great deal going forward. "At this point, the stocks are fairly valued relative to gold," says Bill Martin, portfolio manager for American Century Global Gold Investors, up 31.23%, the best-performing fund for the quarter. "To go higher, gold prices will have to make further gains, and that's going to be tough. People are suspect that these prices will even stick."
Funds that invest in Japan were the other big winner for the quarter, up 17.16%. For a long time, they weren't much more popular than gold funds, even though the Tokyo stock market has sparkled for most of the year. A strengthening yen made these funds look even better. Still, relatively few fund investors shared in this move--U.S.-based mutual funds investing only in Japan have assets of just $6 billion.
This is not the first time the Japanese stock market rallied during its decade-long bear market, of course. And each rally subsequently proved to be a false start. But this time really is different, portfolio managers insist. "The economics are positive," says Seung Kwak, manager of the $1 billion Japan Fund. "There's fiscal stimulus, and banks are in much better shape than they have been in years." Todd Jacobson, co-manager of two Warburg Pincus funds that invest in Japan, adds that Japanese companies are finally starting to do what their U.S. counterparts did a decade ago: restructure, focus on earnings growth, and create value for shareholders.
There's more than one way to play Japan's rebound. T. Rowe Price International Discovery Fund is shining once again--up 18.5% this quarter and 59.2% year-to-date--thanks, in part, to a 25% stake in Japanese small-company stocks the fund established last November. "They were just too cheap to ignore," says Justin Thomson, the fund's portfolio manager. Thomson, who took over the small-cap fund a year ago, also dropped the fund's emerging market stocks altogether, except for those in India. "That's the one emerging market where smaller companies actually have intellectual property and add value," says Thomson, who has about 7% of the fund's assets in India.
Those who own Eaton Vance Greater India B know what Thomson is talking about, and then some. The fund, up 30.8% for the quarter, is a pure play on the world's second-most-populous nation. "Restructuring is bearing fruit," says Zaheer Sitabkhan, the fund's portfolio manager. "On small increases in revenues, these companies are producing big increases in profits." What's also positive is an equity-friendly climate: Capital-gains taxes have been halved, and dividends are now tax-free. There is political risk, though. Tensions with Pakistan over nuclear weapons and fighting in Kashmir, plus Oct. 6 elections, could change the investment picture.
HEALTHY BIOTECHS. Although U.S. funds were hard-pressed to keep up with global recovery plays, they did have their bright spots. Nevis Fund, a mid-cap growth fund that came out of obscurity earlier this year with a concentrated portfolio of technology, telecom, and health-care stocks, continued to sparkle with a 20.85% third-quarter gain that brings the year-to-date return to 153.6%. And funds legend Garrett R. Van Wagoner has kept his comeback on track. Van Wagoner Emerging Growth Fund gained 19.22% in this difficult quarter, bringing its year-to-date performance to 145.1%. Van Wagoner Micro-Cap gained another 18.95%, lifting its 1999 return to 111.1%.
Biotech funds stood out as well. "More companies are making money, more companies are delivering positive earnings surprises, and acquirers are paying good money to buy them," says Kurt von Emster, portfolio manager of Franklin Biotechnology Discovery A, up 22.7% for the quarter. Biotech investments, along with high tech, are also fueling stellar performance at more diversified small-cap funds, such as Strong Enterprise, up 19.41% for the quarter and Northstar Special B, up 18.3%. "Health-care services are problematic, and big drug companies' growth is slowing," says Mary Lisanti, portfolio manager of Northstar Special. "That makes biotech the only game if a portfolio manager wants exposure to health care."
On the bond-fund side, it's a lot harder for portfolio managers to stand out. But Margaret D. Patel, portfolio manager of the Third Avenue High-Yield Fund, managed to do it, achieving a 4.42% total return for the quarter, vs. a -2.03% return for the average high-yield fund. Her secret weapon: "busted converts," convertible bonds whose underlying stock price is so low that the conversion feature is essentially worthless. If the underlying stock recovers, however, these bonds could be worth a lot. If not, the bonds still pay high interest. The key, she says, is to identify the bond where the underlying stock is going to get a whole lot better. "I've tripled my money on some converts," says Patel. "That would not have happened with a regular high-yield bond."
But lately Patel, who has moved to Pioneer Funds but continues to manage Third Avenue, has been shifting away from busted converts to regular bonds. The allure: The high-yield premium over Treasuries is five percentage points. If the premium holds, the bonds should deliver about 10.5% over the next year, "which, until four years ago, used to be considered an equity-like return." Another quarter or two like the last one, and it may be a return that equity-fund shareholders would be glad to earn.