Slim pickings. That's how veteran fund manager Bob Rodriguez describes the investment outlook today. "Our cash levels have never been higher," says Rodriguez, who has run both bond fund FPA New Income (FPWIX ) and stock fund FPA Capital (FPPTX ) for the past 20 years. "This is a terrible time to invest." Rodriguez is convinced that inflation and rising interest rates will kill bonds, and that stocks of all stripes are overvalued. He's on the sidelines with over 35% cash positions in both funds. Other fund notables also holding double-digit cash positions are: PIMCO Total Return's Bill Gross, Longleaf Partners' Mason Hawkins, Clipper Fund's James Gipson, and First Eagle Global's Jean-Marie Eveillard.
Given how mutual funds have performed lately, investors might be tempted to do the same. Year to date, the average equity fund has tallied a total return of only 1.8%, lagging the Standard & Poor's 500-stock index's minuscule 2.9%. Meanwhile, the average bond fund has lost 1.2%, thanks to inflation and interest-rate fears. Even after drilling down to specific fund categories, the returns have been meager at best.
Your best bet now could be to seek funds that are concentrated in just a few stocks or sectors. That makes sense given the general lack of investment opportunities. Top performers, such as ProFunds UltraWireless (WCPSX ), up 31%, and Amerindo Technology (ATCHX ), up 23.3%, have the bulk of their assets in their top five holdings. Even among diversified funds, it has become a stockpicker's market and is expected to remain so. "Investors are more selective now," says Ron Baron, whose top-performing Baron Partners Fund (BPTRX ) -- up 17.6% year-to-date -- has 44% of its assets in four stocks. "The only stocks rising are those of companies with strong cash flow and management teams."
Such behavior is typical in a stock market recovery. The weakest players that survived the downturn snap back first, then stronger companies take over. This is especially true now, with the economy facing headwinds of higher inflation and interest rates. Only companies that can grow in such an environment will prosper. Baron's top holding, ChoicePoint (CPS ), is a good example. As the leading preemployment screening service, the company has "more information about anyone in America than anyone else," says Baron, including health, criminal, and work records. That data has become increasingly valuable to the government and insurers in an age of terrorism and rising health-care costs.
Having a concentrated portfolio has also paid off in the tech sector, where the average fund has lost 1.6% so far this year. Yahoo! (YHOO ), eBay (EBAY ), and InterActiveCorp (IACI ) account for a third of top performer Amerindo Technology's portfolio, while biotech and other Internet stocks make up most of the rest. "About 99% of the average tech fund is invested in yesterday's technology," says Amerindo manager Alberto Vilar. "Microsoft (MSFT ) and Cisco Systems (CSCO ) are mature companies with mediocre growth prospects." Despite a huge run-up in dot-com stock prices since the bust, Vilar argues that we are in the early innings of their upswing. And this time, unlike during their run in the 1990s, they're making money.
Some of this year's top funds have invested heavily in health care and energy. Manager Scott Schoelzel of Janus Twenty Fund (JAVLX ), up 7.9% this year, thinks biotech companies such as Genentech (DNA ), which has developed a drug to treat colon cancer, hold the most promise. "This decade and the next will be focused on treating cancer," he says, a point bolstered by breakthrough results presented at the recent meeting of American Society of Clinical Oncology. Schoelzel's fund is also concentrated, having just 40% of assets in his top five stocks and a 7% weighting in Genentech, which, he says, has been an "enormous contributor to performance."
Inflation, a major worry for investors, isn't much of a concern for Genentech since patients or their insurance companies will usually pay whatever it costs to fight cancer. But not every fund manager is willing to pay whatever it costs to own Genentech. "Biotech companies don't have low valuations," says portfolio manager Jim Barrow of the $25 billion Vanguard Windsor II Fund (VWWFX ), up 5.4% this year. "And I can't make heads or tails of their businesses." Still, Barrow is investing in large health-care stocks, which are usually considered too pricey for value managers like him. "If you have a long-term focus, drug stocks such as Bristol-Myers Squibb (BMY ), Schering-Plough (SGP ), and Baxter International (BAX ) look pretty cheap," he says. He points to their high dividend yields, which all exceed the S&P 500's 1.6% average, as evidence of their value.
While energy and natural-resource stock funds have benefited from the recent climb in oil prices -- up a moderate 5.1% this year -- Oppenheimer Real Asset Fund (QRAAX ) has gained 15.5% by focusing on oil itself. It invests in bonds linked directly to commodity prices, and its oil exposure accounts for more than 55% of its holdings. That said, oil stocks may be a better bargain than the commodity itself, says Vanguard's Barrow. He's betting on large, integrated oil companies such as ConocoPhillips (COP ), Occidental Petroleum (OXY ), and ChevronTexaco (CVX ). "The market is pricing these stocks with the assumption that oil will be $25 a barrel down the road," he says. "It's $40 a barrel right now, and I think it will stay in the $30-to-$50-a-barrel range going forward. Investors don't realize there are real shortages in supply."
If oil were the only driver of inflation, U.S. investors wouldn't have much to worry about, since it isn't as crucial to our economy as it was in the 1970s, when two bouts of rapidly rising oil prices rocked the nation. But Rodriguez argues that the consumer price index (CPI) understates cost increases in health care, housing, and automobiles, and that added inflation will push interest rates higher and bond prices lower than most expect.
Portfolio manager Joseph Deane doesn't expect a nasty bout of inflation but knows that even the widely anticipated increase in interest rates can damage his Smith Barney Managed Municipals Fund (SHMMX ). He sold off all of his longest-maturity municipal bonds, which are more rate-sensitive, and has begun hedging others. Says Deane: "There is no upside in the bond market." Indeed, funds that short or bet against bonds such as Rydex Juno (RYJUX ) and ProFunds Rising Rates Opportunity (RRPIX ) have been among this year's best performers because of rising rates, gaining 2.8% and 3.5% respectively. They should continue to prosper as yields climb.
For most investors, shorting bonds is too risky, but moving to cash doesn't offer a lot of return with the average money-market fund yielding about 1%. "There's $2 trillion bottled up in money-market funds that by law have to adhere to strict requirements as to maturity and credit quality," says Tad Rivelle, chief investment officer of Metropolitan West Asset Management, a Los Angeles bond investment firm. "But securities that don't quite fit those criteria offer a lot more yield."
So last June, Rivelle launched the Metropolitan West Ultra Short Bond fund, which invests in bonds with maturities slightly longer than the 13-month maximum allowed for money funds. Although the fund doesn't offer the liquidity or perfect stability of a money market, it currently pays a 3.3% yield and has delivered a 1.5% return so far this year. The competition in the ultrashort-bond category is creeping along with just a 0.4% gain.
While many U.S. fund managers complain about a lack of good opportunities, those operating abroad are finding more. "It's not heaven from a bargain-hunting perspective, but it's certainly better than the U.S.," says John Spears, co-manager of the $5 billion Tweedy Browne Global Value Fund (TBGVX ), up 11% this year. Spears has been buying small Korean companies, which he says are "incredibly cheap," plus Dutch brewer Heineken and German drugmakers Merck and Schwarz Pharma.
The biggest gains overseas this year have been in Japan, and U.S. funds specializing in Japan are the best-performing fund category this year. "Consumer confidence has returned to Japan," says Paul Matthews, chief investment officer of Matthews Asian Funds. "Employment is stabilizing, and businesses are becoming more efficient and restructuring to boost their earnings. So the market is going up."
One investment definitely not going up is the GE Contra Fund. The year's worst performer, down 93.8%, is a bearish fund that invests mainly in put options -- financial contracts that rise in value if a security or index falls below a target price. The problem was the market didn't fall enough, and the options expired worthless. Ron Rough, a portfolio director at fund manager GE Private Asset Management, says the Contra fund is used only in conjunction with other funds to offset risk in clients' portfolios. "We're generally not putting more than 2% or 3% of a client's assets in this fund," he says. Luckily, GE Contra is not open to the general public.
By Lewis Braham