Don't Hit The Ejection Button Just Yet

No, it's not one of those nasty accounting errors in mutual funds that you've been reading about lately. The awful figures on these pages are all too true. Whether they invested in big- or small-cap stocks, government bonds or munis, mutual funds posted losses across the board. Fund losses were even worse than the overall market, despite the cash cushions in many fund portfolios. Yet month after month, through stormy and fair weather alike, investors doggedly poured money into funds.

Clearly, mutual fund investors are not giving up. It is a strategy of "Patience Pays" -- and so far, it hasn't quite paid off. As Don Phillips, editor of Morningstar Mutual Funds, somberly notes: "Investors got conditioned in the 1987 crash, and in 1989 and 1990, to buy on dips. And that suddenly didn't work in 1994."

This, in a nutshell, is the somber question facing fund investors: Is it finally time to cash out of mutual funds? Will patience begin to pay off--or will investors get another slap in the face in 1995? It's a question that can't, of course, be divorced from the fate of the equity and bond markets. Still, even the most risk-hating investors can ride out the stormy markets without pulling out of funds entirely. And for the more venturesome, fund investing is actually more attractive than ever. Some of the most bedraggled funds, such as growth-stock portfolios and ones sensitive to interest rates, would look mighty attractive if the market begins to turn. Even if it doesn't, there are safe harbors aplenty for more risk-averse investors.

Pretty much any venture into the plus column would be attractive after the mediocre showing funds recorded in 1994. Through Dec. 9, diversified equity funds recorded a decline of 5.36%, nearly four percentage points worse than the 1.6% drop in the Standard & Poor's 500-stock index. Among the laggards was the very biggest fund, $36 billion Fidelity Magellan, with other growth-stock funds such as Twentieth Century Ultra Investors turning in some of the sorriest results.

Only one stock-fund category made it into the plus category--the worst showing since 1990. Technology stocks turned in a 3.5% gain that would have seemed anemic in years when the market was well into the double-digits. The only other category to come close to breaking even was health care. Among the losers were precious metals funds, down 16.3%, and utility funds, which were heavily promoted earlier in the year as a wager on lower rates. There was no refuge abroad, with overseas funds turning lower as the global market rally cooled off. Funds specializing in Pacific Rim exchanges, especially once-hot Japanese funds, were mercilessly pummeled.

Likewise, bond funds were victims of the interest-rate climb, as every fixed-income category recorded a decline. Junk-bond funds, high-quality corporates, muni-bond funds, and global-bond funds each recorded the almost eerily similar loss of anywhere between 2% and 4%.

One fundamental rule of fund investing is particularly worth emphasizing nowadays: Stellar performance by a given fund group is hard to sustain. The investment princes of '94 are more than likely to become toads in '95, and history has shown that laggards often turn up in the following year. One notable exception to that rule is likely to be gold funds, which posted atrocious results in '94 and are unlikely to stage a rebound in the coming year.

LESS VOLATILE. With fixed-income markets turning in their worst performance since the double-digit inflation of 1980, bond funds may well provide some of the most intriguing opportunities of all funds. One comparatively safe way of playing the bond market is via short-term bond funds, which provide comparatively handsome returns with minimal volatility.

One advocate of that strategy is Kurt Brouwer, president of Brouwer & Janachowski, a $350 million money-management firm specializing in mutual funds. Brouwer favors the PIMCo Low Duration fund, whose manager, William H. Gross, is described by Brouwer as the "best bond-fund manager in the country." This fund caters mainly to institutions, and there is a hefty minimum investment of $700,000. However, Brouwer notes that it's just $1,000 if purchased through the discount broker Charles Schwab Corp. Brouwer also likes the Vanguard Short-Term Fixed Income fund, which has a two-year average duration and a 6% current yield. "If rates go up," Brouwer says, "it won't be hurt too badly."

The Vanguard funds are also noted for one of the no-brainer investments of the bull market: index funds, which aim to closely track market indices. Such funds are popular among institutions but less so among individual investors--a shame, perhaps, because most funds have not been able to match or beat the market in recent years. If you believe the market is going to stage a broad advance, the index funds are for you. Otherwise, stay away. Such funds discourage market timers and are tough to swiftly redeem if you want to cut your losses during a sharp market setback. But with the markets behaving inconsistently, fund investors may be better off latching on to a smart stock-picker. Norman G. Fosback, editor of the Mutual Fund Forecaster newsletter, says that one fund family noted for its canny stock picks is the low-volatility Mutual Series funds, run by noted value-stock buyer Michael Price.

Like many market observers nowadays, Fosback is wary about the market and has recommended that investors put 60% of their assets into cash. However, he feels that investors with a longer time horizon and more bullish stance should go into the Mutual Series or even more aggressive funds. Among the growth funds he favors are Twentieth Century Ultra and Fidelity Magellan, despite their less-than-glowing performance this year. Such funds should do especially well if the prevailing sentiment turns out to be wrong--as it often does--and the economy shows signs of persistent strength, thereby boosting earnings and share prices. (The conventional wisdom nowadays is that the economy will soften.)

Junk-bond funds are another way of playing the contrarian game of betting on a continuing robust economy. Junk funds were mediocre performers this year, falling 4.7%, but, unlike other bond funds, should prosper if the economy remains strong. "If defaults are low, and rates turn down, these funds should do well--there's every reason to expect double-digit returns," Fosback asserts. Among the junk funds, he favors the Northeast Investors and Invesco High Yield funds, which both yield 10%.

Investors with a really adventurous perspective may take a flier on small-cap funds. With the exception of funds that invested in technology and some health-care stocks, small funds were crummy performers in '94, with a 6.3% decline. Brouwer likes a new fund called Royce Premier, managed by Charles M. Royce, who runs an old small-cap standby, the Pennsylvania mutual fund. Brouwer notes that Royce Premier is a "more concentrated, smaller" version of Pennsylvania. Sheldon Jacobs, editor of the No Load Fund Observer newsletter, favors the Burger Small Company fund among his roster of small-cap picks.

Another risky, super-contrarian maneuver is to buy into bond funds whose portfolios have long durations, such as zero-coupon ones. Those are especially volatile, and thus present a big payoff if long-bond rates fall--and a major danger if they climb. Which way will they move? Economists surveyed by BUSINESS WEEK came to no broad consensus, although they do believe that the Fed will tighten, causing an increase in short rates in the first half of 1995.

GO GLOBAL. Interest-rate hikes would, of course, continue to put under pressure rate-sensitive stocks as well as bonds. Income-oriented mutual funds produced a 4.8% decline, only a tad better than the average fund, during 1994. However, they will swiftly revive at the first sign of a bond market revival. One stock fund favored by the bearish Fosback is Lindner Dividend, a venerable income fund.

Global funds didn't provide much protection from the travails of the U.S. markets in '94, being fairly miserable in their own right. But smart investors who haven't taken the plunge into international and global funds (ones that can buy both overseas and in the U.S.) should do so now. Jacobs, at the No Load Fund Observer, favors two old standbys in the international investing set: Fidelity Worldwide and Janus Worldwide. Another one widely favored by professional fund pickers is Tweedy Brown Global Value, a New York-based fund with a strong value orientation that it applies to investing in the more-liquid stock markets overseas. Brouwer also favors the Warburg Pincus International Equity fund, which has broad experience in the overseas bourses and invests in emerging markets as well as established ones.

None of these strategies will work, of course, if the domestic and global markets stage a bone-crunching decline. But mutual fund investors have been "knee-jerk contrarians" in the past--and they have been rewarded. Betting against the experts was smart in '89 and '90--and it's just as smart today.

      PERFORMED IN 1994
                         TOTAL RE TURN*/PERCENT
      SPECIALTY-TECHNOLOGY        3.49
      SPECIALTY-HEALTH           -0.42
      EUROPE                     -1.14
      FOREIGN                    -2.74
      EQUITY-INCOME              -4.06
      GROWTH & INCOME            -4.14
      INTERNATIONAL EQUITY       -4.31
      WORLD                      -4.47
      BALANCED                   -4.56
      ASSET ALLOCATION           -4.72
      INCOME                     -4.83
      RESOURCES                  -4.86
      EQUITY FUNDS               -5.39
      GROWTH                     -5.63
      SPECIALTY-FINANCIAL        -6.18
      SMALL COMPANY              -6.26
      MAXIMUM GROWTH             -8.09
      SPECIALTY-UTILITIES        -8.70
      PACIFIC                   -11.34
      METALS                    -16.28
      ALL EQUITY FUNDS           -5.30
      DIVERSIFIED U.S. EQUITY    -5.36
      S&P 500 INDEX              -1.64
      *Appreciation plus reinvested dividends and capital gains through Dec. 9
                            ASSETS*  TOTAL RETURN**
                          BILLIONS  1994    5-YR AVG.
      Fidelity Magellan       $36.0   -6.79%  11.08%
      Investment Company      19.2    -1.98   8.55
      of America
      Washington Mutual       12.6    -1.34   8.01
      Fidelity Asset Manager  11.6    -5.39   11.45
      Fidelity Puritan        11.5    0.37    10.54
      Vanguard/Windsor        11.4    -1.65   8.01
      Income Fund of          10.5    -3.81   8.28
      Twentieth Century        9.7     -8.70   15.07
      Ultra Investors
                             ASSETS*  TOTAL RETURN**
                             BILLIONS  1994    5-YR AVG.
      Vanguard Index 500      9.5     -1.65%  8.21%
      Janus                   9.4     -2.94   10.55
      Fidelity Growth         9.1     -1.27   11.98
      & Income
      Vanguard/Wellington     8.9     -2.83   7.76
      Fidelity Contrafund     8.5     -5.30   16.64
      Vanguard/Windsor II     8.2     -2.97   7.48
      EuroPacific Growth      8.2     -0.15   11.06
      Equity-Income II        7.6     0.37    NA
      Fidelity Equity-Income  7.3     -2.08   8.82
      Dean Witter Dividend    6.6     -5.45   6.94
      Growth Secs
                             ASSETS*  TOTAL RETURN**
                            BILLIONS   1994    5-YR AVG.
      Merrill Lynch Global    6.5     -2.89%  11.12%
      Allocation B
      New Perspective         6.4     0.47    10.36
      T. Rowe Price           6.2     -2.30   7.64
      International Stock
      Vanguard/Wellesley      5.9     -5.14   8.49
      Putnam Fund for         5.8     -2.87   8.77
      Growth & Income A
      Templeton Growth        5.5     -0.32   10.87
      Growth Fund of America  5.3     -3.59   9.10
      *As of Sept. 30
      **Includes dividends and capital gains; all 1994 return data through Dec. 9
           THE BEST
                            TOTAL RETURN*/PERCENT
      Seligman Communications             26.66
      DFA Japanese Small Company          22.94
      Merrill Lynch Technology B          21.74
      Capstone Nikko Japan                20.68
      Alliance Technology A               18.99
      Fidelity Select Health Care         18.78
      Govett Smaller Companies            18.09
      Robertson Stephens Value + Growth   15.93
      Fidelity Select Computers           15.81
      Montgomery Growth                   15.05
      Janus Mercury                       13.94
      PBHG Emerging Growth                13.49
      Fidelity Japan                      12.74
      Fidelity Select Medical Delivery    12.04
      Fidelity Select Electronics         11.85
      T. Rowe Price Japan                 11.24
      G.T. Latin America Growth A         10.85
      Franklin CA Growth                  10.76
      Putnam Health Sciences A            10.65
      Perkins Opportunity                 10.64
      Strong Growth                       10.40
      Pioneer Capital Growth A             9.78
      G.T. Global America Growth A         9.72
      Morgan Stanley Instl Intl Equity     9.60
      Fidelity Select Chemicals            9.60
      Franklin Global Health Care          9.30
      Clover Capital Equity Value          9.17
      DFA Continental Small Company        9.11
      Berger Small Company Growth          9.00
      Vanguard Intl Equity Index Pacific   8.49
      Wright EquiFund-Dutch Natl Fid
      Equity                               8.48
      T. Rowe Price Science & Technology   8.44
      Fidelity Select Paper & Forest Prod  8.35
      ONE Fund International               7.72
      BT Investment Small Cap              7.65
      Fidelity Select Developing Comm      7.34
      Scudder Latin America                7.29
      Invesco Balanced                     7.23
      Safeco Equity                        7.16
      Crabbe Huson Special                 7.02
      SoGen Overseas                       6.87
      Vanguard/Primecap                    6.74
      Quantitative International Eqty Ord  6.70
      BT Investment Latin American Equity  6.58
      AIM Aggressive Growth                6.50
      Japan                                6.49
      Waddell & Reed Growth                6.31
      Yacktman                             6.29
      Parnassus                            6.16
      FPA Paramount                        5.98
                                  TOTAL RETURN*/PERCENT
      Monitrend Gold                     -52.38
      Steadman American Industry         -40.38
      Wright EquiFund-Hong Kong Natl
      Fid Eq                             -39.92
      Steadman Ocean Technology & Growth -36.29
      American Heritage                  -35.95
      Steadman Investment                -34.51
      BJB International Equity A         -32.93
      Capstone Balanced                  -32.02
      Invesco Strategic Gold             -31.56
      Oppenheimer Global Emerging Growth -28.95
      Rydex Precious Metals              -28.61
      Fidelity Southeast Asia            -25.53
      Bull & Bear Special Equities       -25.36
      CGM Capital Development            -25.26
      EV Marathon Greater Cina Growth    -25.02
      Fidelity Select Air Transportation -25.02
      EV Classic Greater China Growth    -25.02
      59 Wall Street Pacific Basin
      Equity                             -24.23
      Gintel ERISA                       -24.11
      Excel Value                        -24.02
      Excel Midas Gold                   -23.37
      Van Eck Asia Dynasty A             -23.17
      T. Rowe Price New Asia             -22.85
      OVB Emerging Growth A              -22.56
      MFS Gold & Natural Resources B     -22.47
      G.T. Global New Pacific Growth A   -22.19
      Merrill Lynch Dragon B             -21.76
      United Services World Gold          21.36
      Dean Witter Pacific Growth         -21.36
      Fidelity Select Brokerage &
      Investmnt                          -21.26
      BT Investment Pacific Basin Equity -21.15
      Aetna Asian Growth Sel             -21.10
      Victory Special Growth             -21.01
      Dreyfus Special Growth Inv         -20.96
      First Mutual                       -20.54
      Fidelity Select Biotechnology      -20.52
      Fidelity Select Construction
      & Housing                          -20.49
      Morgan Stanley Instl Asian Equity  -20.39
      Benham Gold Equities Index         -20.34
      United Gold & Government           -19.91
      Bull & Bear Gold Investors         -19.71
      Gintel                             -19.46
      Steadman Associated                -19.28
      Weitz Hickory                      -19.12
      Fidelity Select American Gold      -19.11
      Van Eck Gold/Resources             -19.09
      Morgan Stanley Asian Growth B      -19.05
      Scudder Pacific Opportunities      -18.88
      Keystone Precious Metals Holdings  -18.87
      Fidelity Select Automotive         -18.67
      *Appreciation plus reinvested dividends and capital gains, through Dec. 9, 1994 DATA: MORNINGSTAR INC.
      Bond funds offer some of the best opportunities -and short-term bond funds deliver both handsome returns and minimal volatility
                             THE BEST BOND FUNDS
                                          TOTAL RETURN*
      Fidelity Deutsche Mark Performance      14.11%
      Franklin/Templeton Hard Currency        13.28
      Fidelity Yen Performance                12.24
      Fidelity Sterling Performance            9.21
      Franklin/Templeton High-Inc Currency     8.96
      Franklin/Templeton German Govt Bond      8.15
      Franklin/Templeton Global Currency       7.03
      Hotchkis & Wiley Low Duration            4.34
      MetLife Portfolios Intl Fixed-Inc C      3.75
      Seven Seas Yield Plus                    3.70
      Smith Breeden Short Dur U.S. Govt        3.55
      Benchmark Short Duration                 3.43
      Smith Breeden Short Dur U.S. Govt Ser    3.40
      Strong Advantage                         3.39
      FFTW U.S. Short-Term Fixed-Income        3.38
      Regis Sirach Short-Term Reserves         3.34
      Eaton Vance Short-Term Treasury          3.22
      RSI Retirement Trust Short-Term Invmt    3.12
      Permanent Portfolio Treasury Bill        3.05
      First American Managed Income A          2.98
      Average of 987 funds                    -3.72%
                                          TOTAL RETURN*
      Hanifen, Imhoff CO BondShares            5.70%
      Calvert Tax-Free Reserv Limited-Trm A    2.31
      Twentieth Century Tax-Exmpt Short-Trm    2.20
      Venture Muni (+) Plus B                  1.49
      Vanguard Municipal Short-Term            1.42
      Merrill Lynch Municipal Ltd Maturity A   1.00
      Colonial Short-Term Tax-Exempt           0.84
      Merrill Lynch Municipal Ltd Maturity B   0.68
      Dupree KY Tax-Free Short-to-Medium       0.68
      USAA Tax-Exempt Short-Term               0.43
      Pacifica Short-Term CA Tax-Free          0.41
      T. Rowe Price MD Short-Term Tax-Free     0.29
      Kent MI Muni Ltd Maturity Bond Instl     0.01
      Kent MI Muni Ltd Maturity Bond Invmt    -0.09
      59 Wall Street Tax-Free Sh-Interm F/I   -0.17
      Vanguard Municipal Limited-Term         -0.21
      T. Rowe Price Tax-Free Short-Interm     -0.26
      Merrill Lynch NY Ltd Maturity Muni A    -0.31
      Average of 891 funds                    -7.08%
      *Appreciation plus reinvested dividends and capital gains through Dec. 9
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