The investing climate for mutual funds was warmer in Siberia than Silicon Valley in 2001. In what turned out to be another topsy-turvy year, Russian stock funds soared while tech funds nosedived. If you need further evidence of how weird 2001 was, look at gold funds. The worst performers over the past two decades, they were tops--up an average of 16.5% (table).
With a lousy economy and a sinking stock market, equity funds were doomed. But believe it or not, they outperformed the Standard & Poor's 500-stock index. The total return of U.S. diversified equity funds was down an average -11.4%, vs. the S&P's -12.8% drop. (Returns are as of Dec. 12 and include appreciation plus reinvestment of dividends and capital gains before taxes. The data is prepared for BusinessWeek by Standard & Poor's.)
Still, there was something familiar about the 2001 results. Small-cap stock funds beat large-cap, value funds bested growth, and steady-Eddie bond funds rose 4.7%. International funds, down 17.2%, provided little haven for U.S. investors.
Fund shareholders didn't take kindly to their sinking fortunes. New money put into stock funds dried up, to just $15 billion in 2001 through the end of October--a 95% drop from 2000. The returns from the nation's largest funds were particularly disappointing. Not one of the top 10 delivered a gain, although six lost less than the S&P. Meanwhile, the rivalry continued between the actively managed Fidelity Magellan Fund and the passive Vanguard 500 Index Fund. The two were neck and neck all year, ending it with nearly identical returns.
Among diversified stock funds, the only beacons were in the small-cap value category, which rose 11.1% as investors fled large stocks en masse. The best performers concentrated their portfolios in just a few positions. Ameristock Focused Value Fund, up 58.3%, has 60% of its assets in five tiny stocks. "We're not seeing nearly as many bargain small-cap stocks as we did a year ago," says portfolio manager Nicholas D. Gerber.
Not all small-cap managers agree. "Small-cap stocks are still extremely cheap relative to large," says G. Kenneth Heebner, portfolio manager of CGM Focus Fund. For example, CGM's stake in homebuilder Beazer Homes USA Inc., though up 42.7%, trades at about a third of the price-earnings ratio of the S&P 500. "Beazer could triple in 2002," Heebner says. He also concentrates his positions and has the ability to sell short, or bet against stocks. Although not short now, CGM Focus made money in 2001 shorting dot-com stocks.
Growth funds suffered across all market caps. The few that managed to stay in the black succeeded by avoiding the tech minefields. "It was Business 101 for us," says portfolio manager John C. Thompson, whose large-cap Thompson Plumb Growth Fund was up 14.2%. "We avoided companies that weren't profitable--Internet, telecom equipment, and wireless stocks."
Thompson did buy some profitable tech stocks, such as Microsoft Corp., after September 11. He has benefited from the fourth-quarter rally, sparked by the growing belief the economy will recover sooner with additional fiscal stimulus and tax cuts. But with the tech-heavy Nasdaq Composite Index up 34% in the fourth quarter, many fund managers now think the rally is overblown. "Nothing has changed in the fundamentals of technology to warrant this kind of move," says Ajay Krishnan, portfolio manager of Wasatch Global Technology Fund.
Few sectors proved immune to the economic slowdown. While stalwart health-care and financial-services funds were safe havens in 2000, they stumbled in 2001, their averages falling 15.7% and 3.9%, respectively. "Financial-service stocks live and die on interest rates and credit quality," says David H. Ellison, portfolio manager of FBR Small Cap Financial Fund. "Lower interest rates were no problem, but everybody was worried about banks having a lot of nonperforming loans." Ellison delivered a 19.7% return by sticking to regional banks and thrifts with clean balance sheets.
The rally in gold funds may seem surprising after so many miserable years, but it's understandable given 2001's ugly economic climate. "Gold takes on the role of a pseudo-currency when investors panic," says William Martin, who runs the American Century Global Gold Fund, up 30.3%. "It's there to protect you from the complete unknown." Lower interest rates, a volatile U.S. dollar, and a demand-supply imbalance also gave the sector a boost.
Besides gold, real estate was the only positive fund sector, up 8.4% on average. "Real estate appeals to investors in this environment because of the relative certainty of the sector's cash flow," says Michael Winer, portfolio manager of the Third Avenue Real Estate Value Fund. Unlike most stocks, where the next quarter's earnings are anybody's guess, commercial real estate companies lock in their revenue in advance through long leases. "Unless your tenants go bankrupt, your cash flow for the next three to four years is very visible," Winer says.
Foreign funds had an even bleaker year than their U.S. cousins: Less than 40 had positive results. The reason, some money managers say, is the telecom and tech bubble of the 1990s was even more exaggerated overseas. "It was obvious during the bubble that there was a scarcity of legitimate foreign tech stocks," says Michael Welsh, portfolio manager of Oakmark International Small Cap Fund. "All of these tangential European media and telecom companies were being dubbed hot Internet stocks, even though they were slow growers." The crash hit them harder.
Small stocks also rallied overseas, enabling Oakmark's fund to deliver a 9.9% return. Otherwise, only a few single-country funds racked up gains. Pilgrim Russia, with a 69.7% return, was the best-performing mutual fund this year, followed closely by Matthews Korea Fund (table). Pilgrim's Samuel Oubadia says Russia's cheap oil stocks, 2001 tax cuts, and improving corporate governance were the main reasons for the surge. With oil prices now falling, 2002's outlook may not be as sanguine.
Once again, bond funds triumphed, with every category rising except convertible bonds, which fell 8.2%. (Convertible returns tend to follow the stock market.) Even junk-bond funds, after a brutal 2000, managed to eke out a 1.5% total return. Many debt experts now think junk is set for an excellent 2002. Although yields in the junk market, which average 12.92%, are enticing, winnowing out the chaff can be difficult--and that's where a shrewd manager comes in. Pioneer High Yield Fund, up 15.5%, was the best in 2001.
With all the global jitters, who would have expected emerging-market debt funds--up 10.2% on average--to do so well? "As interest rates declined in developed nations, a lot of investors looked for yield in emerging markets," says Mohamed A. El-Erian, manager of PIMCO Emerging Markets Bond Fund, which soared 28.3% in 2001. Since emerging bonds are primarily government issues, El-Erian thinks they're less likely to default than junk debt. "Russia has over $30 billion in reserves to service its bonds," El-Erian says. "It's hard to find a junk-bond company with that much cash." Although arguably safer than junk, Russian bonds still yield 13%.
Most bond managers agree that U.S. Treasury securities are played out. While government bonds had another banner year, Treasury yields, which range between 2% and 5.5%, are now so low the likelihood of a repeat is slim. "It's very rare that the Treasury bond market beats the stock market two years in a row," says S. Kenneth Leech, CIO of Western Asset Management Co., a bond money-management firm. For Treasuries to do well in 2002, investors would have to be fleeing the stock market again. Another victory for this sector would be a hollow one indeed.
By Lewis Braham