Mutual Funds: Tanned, Rested, And Raring

Mutual funds are likely to make their best quarterly showings in more than a year

If the wild gyrations of the stock market make your stomach queasy, try this remedy: Take a look at the recent returns on mutual funds. Even if your funds are only average performers, they've been trouncing the blue chips since midsummer and doing it with less volatility, too.

In the third quarter, mutual funds are likely to make their best showing in more than a year. U.S. diversified equity funds earned an 11.87% total return--including reinvestment of dividends and capital gains (through Sept. 22)--according to Morningstar Inc., which prepares fund data for BUSINESS WEEK. That's more than 3.5 percentage points higher than the 8.25% return of the Standard & Poor's 500-stock index for the same period. The all-equity average, which includes the negative returns from some overseas funds, was only a hairbreadth behind the S&P. And thanks to an improving bond market, bond funds are showing some pep as well. Taxable bond funds gained on average 2.81%, and tax-free funds 2.5%.

THINKING SMALL. No, those fund managers didn't get a whole lot smarter over the summer. What happened is that Wall Streeters, wary of the high valuations and weakening earnings of multinational giants like Coca-Cola, Gillette, and Eastman Kodak, began unloading their S&P 500 stocks and buying long-ignored mid-cap and small-cap shares. That played right into the hands of mutual-fund managers, who typically invest more in those secondary stocks than in the blue chips.

The outlook for the smaller companies--and for the funds that invest in them--continues to be bright. Valuations are still reasonable. "There's no shortage of good, solid earnings improvement stories out there," says Bill Newman, who runs Phoenix Small Cap A, up 28.04% for the quarter. And there's not much threat from sharply higher interest rates or recession, either of which would send smaller companies reeling. The new capital-gains tax cuts gives investors added incentives to seek small-company funds: They pay little if any dividends, and most of their returns are in the form of capital gains. All told, the market's turn to smaller companies should allow the average fund to beat the S&P 500 index for the entire year. That has not happened since 1993.

Certainly, the cash pouring into funds is heading toward the ones that invest in smaller companies. Robert Adler of AMG Data Services says that such funds took in more than $1 billion a week in the first three weeks of September. "That's an awfully large weekly flow, considering these funds have assets of $163 billion," says Adler. Equity funds as a whole are now taking in $4 billion per week, a neat bounceback from August, when a market downdraft caused some investors to close their checkbooks.

UNGLAMOROUS. Among U.S. diversified equity funds in the third quarter, the small-cap funds beat the mid-caps, and the mid-caps beat the large (table, page 58). Small-cap growth funds, those that invest in the less seasoned but fastest-growing companies, raced to the fore with a 16.72% return. Small-cap value funds, which generally work in the less glamorous industrial and financial sectors of the small-company universe, showed an impressive 13.95% total return.

Managers of large-cap funds still found ways to stand out. Nimble large-cap managers who were able to overweight technology and underweight food, tobacco, cosmetics, and beverages found they could beat the S&P 500 index as well. Large-cap growth funds earned a 10.8% return. Even managers of large-cap blend funds, which compete head-on with computer-run S&P 500 index funds, squeaked past the index with a 9% gain.

Funds big in assets also fared nicely. After several years of market-trailing performance, the $60.1 billion Fidelity Magellan Fund delivered a plump 10.42% return (table). Magellan was set to close to new investors on Sept. 30, but the $28.9 billion Fidelity Contrafund, up 11.84% for the quarter, is still open for business. Out of the 10 largest equity funds, 8 beat the index, including Vanguard Index 500 Fund, which topped its bogey by 0.13 percentage points.

Each bull-market surge in small caps also produces a slew of new funds to lure investors. Among them are Bjurman Micro-Cap Growth Fund, the first mutual-fund foray of George D. Bjurman & Associates, a $2.3 billion Los Angeles institutional investment firm. The fund is up 32% for the quarter and 58% since its Mar. 31 launch. It screens for companies with market caps between $30 million and $300 million, choosing those with strong earnings growth and moderate price-earnings and price-to-cash-flow ratios. The fund is also micro in size--less than $2 million. But if it continues to post numbers of that sort, it won't be for long.

CLOSED DOOR. Indeed, the biggest problem facing investors is a dearth of good small-cap fund opportunities. The best ones either get so big that their performance suffers or they move into mid-cap stocks--which become a different sort of investment vehicle.

Others fight to maintain performance and their investment style by closing to new investors. That's what has happened at ni Growth and ni Micro Cap, the two quantitatively driven funds run by John C. Bogle Jr., son of Vanguard Group's founder and chairman. Bogle launched the funds 16 months ago and shut the doors on Aug. 8. "That's the only way to prevent capitalization creep," he says. Portfolio manager John Montgomery of Bridgeway Ultra-Small Company Fund said "no thanks" to new investors when it reached $27 million in June. The fund invests in companies from the bottom 10% in market capitalization, a difficult area in which to invest large sums. The bottom line: If you find an attractive new small-cap offering for your portfolio, don't wait too long.

Besides small caps, funds specializing in technology and in natural resources dominated the top performers. In the No.1 slot, Fidelity Select Computers Portfolio may not be much of a surprise. But just 0.4 percentage points behind is Fidelity Select Energy Service Portfolio, up nearly 36% for the quarter. The $1 billion fund focuses on companies that supply equipment and services to energy companies. "We're running out of production capacity, and incremental demand will have to be met by new production," says portfolio manager Robert Ewing. "We're only in year 3 or 4 of a 15-year energy cycle."

ASIAN LOSERS. A broader-based approach to energy investing is Invesco Strategic Portfolio Energy fund, up 26.32% for the quarter. John S. Segner, who took over the fund last winter, put one-third of its $350 million in oil services, but he also invests in the big international oils and domestic exploration and production companies.

The quarter's big losers all invest in the Far East, where market turmoil and currency devaluation proved devastating, especially for those investing in Malaysia and Thailand. Richard Farrell, who runs Guinness Flight Asia Blue Chip Fund, doesn't think the crises are over, but he is willing to step gingerly into these battered markets. Figuring the domestic economies will be sluggish for some time, he's buying stocks of Malaysian agricultural producers and Thai exporters. Both sectors, he says, should benefit from their now-cheaper currencies. The more diversified of the emerging-markets funds weathered the crises better, down only 4%, compared with a 13.5% loss for diversified Asian funds. One big player, Fidelity Emerging Markets Fund, apparently got caught in the wrong places. It's down 22.54% for the quarter.

The quarter has been a good one for the bond funds. Long-term interest rates came down--a big plus for bond- fund net asset values. Not surprisingly, the top-performing taxable funds were four zero-coupon funds run by American Century-Benham (table). Since they pay no current interest, zeros are highly sensitive to changes in rates.

Of course, bond funds have had some strong quarters in recent years that investors ignored. But now they're starting to pay attention. AMG's Adler says taxable bond funds took in more than $1 billion a week during half of the quarter's weeks, a rate not seen since before 1994's bond-fund debacle. And the money is going not only to high-yield funds but also to investment-grade portfolios. Certainly, it's not the yields on these funds that are drawing the cash. Perhaps market volatility is reminding investors that diversification is just good preventive medicine.

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