This Mutual Fund Party Is Still Jumping
After a torrid three years in which the average U.S. diversified mutual fund doubled its shareholders' investment, you would think the stock market and the funds would take a breather this year. Think again. After a rocky beginning, the stock market is once again zooming ahead at warp speed.
And just as in each of the past four years, the Standard & Poor's 500-stock index, up 13.17% for the quarter (through Mar. 23), is trouncing the average mutual-fund manager. Still, the average equity fund has posted 10% total returns since New Year's (appreciation plus reinvested dividends and capital gains). U.S. diversified funds are up nearly 11% for the first quarter. So who's going to complain?
Certainly not fund investors. They're voting with their dollars--to the tune of $1 billion a day in recent weeks, says Charles Biderman of Trim Tabs Financial Services, a Santa Rosa (Calif.) firm that tracks mutual-fund inflows. At that rate, he says, the funds will take in $20 billion this month and some $54 billion for the quarter. Index funds--low-cost portfolios designed to track a market index rather than beat it--command around 10% of the inflows.
CLOSED WINDOWS. The overwhelming majority of fund buyers still put their money in the hands of stock-pickers. But they're favoring big funds that invest in blue chips, which is another reason small-cap and mid-cap funds continue to lag. Indeed, on Mar. 19, fund giant Fidelity Investments announced it would close three behemoths to new investors--including the $40.9 billion Fidelity Growth & Income and $32.2 billion Fidelity Contrafund--lest the portfolio managers get swamped by the torrents of cash. Fidelity did the same to its Fidelity Magellan Fund last fall--and its performance vs. the S&P 500 has improved (table).
Cash is coming back to bond funds as well, and 1998's first quarter should show the strongest inflows in four years. Still, the money is going mainly into higher-return funds, such as high-yield bond funds, leaving the meat-and-potatoes government and municipal funds all but ignored. Taxable bond funds earned an average 1.76% return so far this year, tax-free funds just 0.76%. The quarter's best-performing bond fund: Phoenix Emerging Markets Bond A, up 9.65% (table, page 116).
Fund investors are also sending their dollars abroad once again. Emboldened by their surprise success at home--the U.S. market has already gained far more than most soothsayers had forecast for the entire year just a few months ago--they are confident enough to go shopping in the battered markets. Look at Matthews Korea I Fund, which between plunging prices and a depreciating currency lost 65% of its net asset value in 1997. It's 1998's best performer, up 62.5% (table). And its assets under management are up sevenfold this year, as bargain hunters pour in. At $108 million, the fund is far larger now than it was before the crisis.
Still, the pain of last year's Asian market meltdown has not entirely gone away. Biderman estimates that by the end of the quarter, cash flows to international funds will be only $4 billion, down from $14 billion in the first quarter of 1997. Still, flows follow performance, and if the international funds continue to make gains, the cash will follow. Foreign funds, which can put their money anywhere except the U.S., are up a market-beating average 13.93% so far this year, according to Morningstar Inc., which prepares the data for BUSINESS WEEK (table, page 116). Even with the Matthews Korea rebound, the Asian funds on average are making only modest gains. The average Pacific/Asia funds that exclude Japan are up 5.26% for the year, and those including Japan just 2.01%. Japanese funds themselves are up only 1.87%.
EURO BOOST. The Asian economies, says fund manager G. Paul Matthews, who runs three other Asian funds in addition to the Korea portfolio, are in varying stages of recovery. The big picture in Korea is encouraging, he says: "We have an agreement with the International Monetary Fund, a new president, some deregulation. From here, it's a company-by-company restructuring story." He's also encouraged by the improvements in the economic and business environment in Thailand and discouraged by the lack of them in Indonesia. As for China, says Matthews, "it's been remarkably stable through the whole crisis."
What's fueling the foreign funds' performance is their European holdings. And funds investing only in Europe are doing even better. They're up an impressive 17.56% this year, atop 17.8% last year and 24.7% in 1996. The reasons for the rise in Europe resemble those in the U.S.: falling interest rates and corporate restructurings. Also helping are the European Monetary Union and the euro, the common currency whose debut is scheduled for next year.
"The EMU can be a catalyst for a lot of positive changes that are needed in Europe, like reform of the welfare system and the development of an equity investment culture," says Carol Franklin, who runs the Scudder Greater Europe Growth Fund. "Companies in Europe are beginning to talk about shareholder value." Laws in several countries have been changed to allow companies to buy back shares, a tactic that has proven powerful in boosting shareholder value in the U.S.
TELECOM TRIUMPH. And just as in the U.S., Europeans are acquiring an appetite for equity investment. "Germans used to invest in bonds, but now they're also buying stocks," says Patrick M. Smith, who manages Pioneer Europe A Fund. "And in Spain, the amount of household financial assets in stocks has gone from 6% to 14% in just a couple of years." Smith has been playing the investment trend by buying shares in European asset-management companies. One of his favorites is Banca Fideuram, an Italian bank that makes most of its money by managing mutual funds. It's up 77% in the past three months and 200% in the past year.
Among the specialty funds, the best showings came from those that hone in on telecommunications stocks. These funds are up an average 19.79% this year. After several years of just middling returns, telecom stock prices soared, thanks to mergers and takeovers, deregulation in local markets, and an explosion in data-transmission traffic. "All three of those factors drive equipment spending," says Brian B. Hayward, who runs the Invesco Worldwide Communications Fund and is a fan of such telecom equipment makers as Lucent Technologies, Northern Telecom, and CIENA. The best telecom fund so far: Montgomery Global Communications R, up 36.42%, which is taking strength from both the industry boom and the foreign play.
Telecom stocks also played a big part in some of the more diversified funds that made it to the top of the list. Jim McCall, manager of the PBHG Large Cap 20 Fund, says his Lucent shares are up 50% this year alone. That pays off in a concentrated fund with only 20 holdings. Northern Telecom is in the portfolio of the Marsico Focus Fund, the new venture of former Janus Twenty Fund superstar Tom Marsico. Marsico's largest holding, though, is Ford Motor Co., making up 11% of the $130 million fund. It's no great growth company, but the core auto business sells for four times earnings.
TIGHT FOCUS. Many fund companies are increasingly offering concentrated or "focused" funds--and the quarter's results, at least, show that when they work well, they do stand out. While many funds have a relatively short list of investments when they are small, only the focused funds remain concentrated as they get larger. Not all these funds have "focus" in their name. Transamerica Premier Aggressive Growth has only 24 stocks. "There are so few really good businesses at any one point in time, and when I have one, I make a big bet on it," says Philip Treick, the portfolio manager. Among his top holdings are Dell Computer Corp. and Pixar.
The extreme opposite of the focused fund is the index fund, and managers are finding new variations on a popular product. One new company, ProFunds, based in Bethesda, Md., managed to make both the best and worst performers' lists with index-like portfolios. UltraOTC ProFunds uses futures and options to double the return of the NASDAQ 100 Index, NASDAQ's 100 largest stocks. The fund is up 38.76% year to date. UltraBull, designed to double the return of the S&P 500, is up 25.17%. Bear ProFund, designed to perform exactly opposite to the S&P 500, is down 10.4%. UltraBear ProFund, which aims to deliver twice the inverse of the S&P, is down 18.63%.
In addition to a few other bear funds, the loser list is dominated by funds specializing in real estate investment trusts (REITs). The sector is down -2.44% for the quarter, the only fund category in the red. In part, REIT prices are sagging because the Clinton Administration is gunning for a treasured tax loophole that benefits a handful of REITs. But G. Kenneth Heebner, who runs CGM Realty Fund, says most likely REITs fell as managers of conservative equity funds traded them in for higher octane stocks when the market took off. "There hasn't been any fundamental disappointment in REITs," says Heebner. "And there's been no great change in the outlook, either." Heebner argues that relative to the S&P, REITs have never been cheaper: "Double the growth rate at half the price."
Sure, the cheapness of REITs makes real estate funds attractive. But what's even more important is that these funds bring diversification to an investor's portfolio. REIT funds have an even lower correlation with the S&P 500 than foreign equity funds or even many bond funds. That's an undervalued attribute when the stock market's on a winning streak. It will be highly valued when that streak ends.