Funds with All the Right Moves

Real estate and small-caps have set the pace, but look to mid- and large-caps for big gains next, says BW's Lauren Young

The best performers among mutual funds? As of the midyear update of BusinessWeek's Mutual Fund Scoreboard, they were small-cap and real estate funds, according to Personal Finance Editor Lauren Young (see BW, 8/2/04, "Mutual Funds: Keeping Fit in a Flat Market").

However, small caps may be near the end of their run, both because of current valuations and because they have been leading for so many years, Young says. In their place, she would look to large-cap funds -- for example, T. Rowe Price Growth Stock Fund (PRGFX ) -- and to the mid-cap area, which could be even better because it gets less attention from the big institutional investors. "One fund in the mid-cap space that scores very high is the ABN Amro Mid-Cap Fund (CHTTX )," Young adds.

As for real estate, Young suggests not worrying about the bubble some see in that area because those concerns focus on the residential market and most real estate funds invest in commercial properties. She notes that there are good values now in apartment and lodging REITs.

These were a few of the points Young made in an investing chat presented July 27 by BusinessWeek Online and Standard & Poor's (both units of The McGraw-Hill Companies) on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BW Online on AOL at keyword: BW Talk.

Q: Lauren, stocks haven't done much so far this year -- can the same be said of equity mutual funds?

A:

The mutual funds, for the most part, haven't been too stellar in terms of performance. There are some sector funds that have done very well, but for the most part, diversified U.S. funds are pretty blah.

Q: Of course, the Scoreboard looks longer-term -- what's the score there?

A:

The score is pretty good. The newcomers that are on the Scoreboard as of midyear tend to gravitate toward small-cap and real estate in terms of performance. Overall the funds that we rate A, which is the highest score using research from Standard & Poor's, are pretty good performers over the long haul. To even be rated, you have to have at least five years of performance.

Q: In your opinion, is it time to pull back on exposure to small-cap funds?

A:

Yes, it is.... The reason why is, first of all, we had an incredible run in small-caps, and small-cap markets run in cycles, typically five to six years -- and we're coming up on the six-year mark. So it seems like, just based on a very historical measure, that there isn't very much room left in the cycle, especially when you couple that with valuations.

Overall, small-caps are relatively expensive.... That said, there are many, many, many small companies, and if the economy really does rebound full-throttle, they should continue to benefit.

Q: Where other than in small-caps would you look? Are you gravitating to the large-caps?

A:

I think that large-caps are a pretty good buy right now. Earnings growth is good. Valuations are much more reasonable than they were back in the go-go period. And I think they just relatively look more appealing right now.

Ditto for mid-cap, which may even be a little bit more enticing in terms of earnings growth and valuation. One other thing mid-caps have going for them is that they tend to be overlooked by institutions, pension funds, and other big investors on Wall Street. So you may find some real gems that others don't see. One fund in the mid-cap space that scores very high is the ABN Amro Mid-Cap Fund (CHTTX ). In the large-cap area, I like the T. Rowe Price Growth Stock Fund (PRGFX ).

Q: Bridgeway Aggressive Investors fund (BRAGX ) and Robertson Stephens Partners Fund (RSPFX )?

A:

Bridgeway is fantastic. [Manager John Montgomery] has a very quantitative way of stock-picking, so he uses computer screens to help him find stocks. I really like John's approach to stock-picking.

As for the RS Partners Fund, it's managed by one of my favorite fund managers, Andy Pilara. Both score very well in terms of BusinessWeek rankings. And they're actually very different from each other, so if you wanted to own both, that would be O.K. because one is more growth-oriented (that being the Bridgeway Fund), and one is more value-oriented (the RS Partners Fund).

Q: What's your opinion of Fidelity's Strategic Income Fund (FSICX )?

A:

FSICX has a good long-term track record, and it did very well when high-yield bonds were rallying. It's one of these multisector bond funds, and it's pretty aggressive, because the fund manager has put money in emerging markets as well as high-yield.

So I don't think it would be the core fixed-income holding in a portfolio -- it's a little too risky for that. But it's definitely an interesting diversifier. That said, this is unfortunately not the best environment for fixed-income investors, because we know rates are rising.... I wouldn't put more than 5% of a fund like this in a portfolio.

Q: How about overseas funds -- and what's your take on the Pacific Rim as an investment?

A:

Big fan of the Pacific Rim! If you look at the world and where the growth is, it's certainly the most exciting place to be right now.... I do think we've had a spectacular run there as well, and it's highly unlikely that it can continue at the same pace, particularly because of China, which can't just go on forever.

However, several fund managers I've spoken to think that the rally in Japan is real. For the Scoreboard, I spoke to Charles De Vaulx, who is the co-manager of the A-rated First Eagle Global Fund (SGENX ), and he's very bullish on Asia right now, particularly Japan, which is still cheap despite the recent rally.

Q: Bjurman Barry Micro Cap Growth (BMCFX ) has a great long-term record -- but getting clobbered this year. Is it time to pull out?

A:

No. I really like that fund a lot.... They just actually opened up another fund, which is the Small Cap Growth Fund (BBSFX ). Anyway, I've always really liked their style...it's down about 16% this year, which is about double what the Russell 2000 Growth Index is, but that's not really surprising given the run we've had in micro-caps. If you're a long-term investor, which I hope you are, you will be very sorry if you sell this fund in 10 years.

Q: What do you think of the ETFs [exchange-traded funds] such as iShares as a long-term investment?

A:

I think iShares are a good long-term investment. Obviously, it depends on which kind of iShares. There are many different flavors out there. I don't know if I would buy the iShares South Africa Fund (ETF ) as the best long-term investment, but if you like indexing, then certainly SPDRs make a lot of sense. If you like technology, the Cubes (QQQ ), which track the Nasdaq, are a great way to get in, especially because of the very low expenses and the tax efficiency.

Q: Do you prefer SPDRs over index funds (open-ended funds), and if so, why?

A:

SPDRs are appealing because they are more tax-efficient, they have lower expenses, and certainly they are easier to trade. But for a long-term investor who likes to put money into the market with discipline, which means someone who prefers dollar-cost averaging, ETFs/SPDRs don't make sense because the transaction costs really add up. For me, the perfect investor is someone who doesn't trade a lot. So the benefit of being able to trade an ETF isn't especially appealing.

Q: Follow-up -- buy VTI or Vanguard Total Stock Index Fund (VTSMX )?

A:

Again, that's going to be a function of how much you trade. If you're a long-term investor, go with the long-term fund, the Total Stock Market Fund. If you plan to own equities for the next six months, go for the ETF, which is VTI. At the end of the day, it's the same portfolio -- the same fund manager -- it's just a different way of accessing the underlying portfolio.

Q: Speaking of the best funds, the BW Mutual Fund Scoreboard has a substantial A list -- what are some of the funds that looked best at midyear? Newcomers?

A:

Well, certainly real estate. Out of the list of 45 newcomers since January, we had 12 real estate funds added to the list. We had 18 small-cap funds in all areas -- value, growth, blend. So those two sectors really dominated at midyear.

Q: With much talk about a real estate bubble, are those sector funds a good buy now despite past performance?

A:

I would say that there are still some compelling reasons to own real estate. The managers I spoke with say that apartment REITs are a very good value, and they also are seeing good values in lodging. So the managers think there's still real estate that isn't wildly overpriced.

Remember, most real estate funds are much more focused on commercial real estate, and some of the crazy mania we're seeing in the residential markets doesn't necessarily translate.

Q: How about another popular sector, health care? Interesting funds there?

A:

Well, I always like the Vanguard Health Care Fund (VGHCX ) -- it's one of my favorites. The Eaton Vance Worldwide Health Science Fund (ETHSX ) is a spectacular fund with more aggressive investments. It was recently added to our list of A-rated funds. Also, the Pimco RCM Global Health Care Fund (DGHCX ) is another new A-rated fund in our Scoreboard.

Q: How are fund managers playing technology stocks these days? Any hints for investors?

A:

I haven't spoken to a lot of people who are wild about tech, now that I think about it. Certainly among the A-rated funds on our list there's not much momentum for tech, but I'm not sure why.

Having said that...the Smith Barney Security & Growth Fund (SAFEX ) has been dabbling in tech...but not loading up on it.... I think people are finding niche opportunities -- I'm just not hearing a lot of buzz about tech right now.

Q: The only sector that S&P now recommends overweighting is energy -- funds there worth checking?

A:

I'm just looking something up. There were no energy funds added to the Scoreboard in June. Invesco has an energy fund, which I've liked for a long time. Vanguard, over the long haul, has performed well, with very low expenses. Overall, I think energy is a very volatile sector, so I would be careful.

Edited by Jack Dierdorff

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