Ouch! Those Measly Fund Returns Hurt

Only Net and large-cap funds soared in the first quarter

If you do most of your investing through mutual funds, you don't have much reason to celebrate the Dow Jones industrial average busting through 10,000 on Mar. 29. The average U.S. diversified equity fund earned a total return of just 1.15% (including reinvestment of dividends and capital gains) this year, vs. a 9% price gain for the Dow. If anything, the hoopla around the 30 Dow stocks was just a painful reminder of the increasing narrowness of a market in which more and more of the gains are concentrated in fewer and fewer stocks.

Mutual-fund investors haven't been totally left on the sidelines. Those who have flocked to index funds have reason to celebrate. Most index funds that investors use track the Standard & Poor's 500-stock index, and the S&P 500--which clobbered the Dow by 10 percentage points in 1998--is still up a hefty 6.8% for the quarter (through Mar. 29). Not surprisingly, cash inflows to index funds are surging, as they've done for several years. And where is that money coming from? "Investors are abandoning managed funds in favor of indexers," says Robert Adler of AMG Data Services, which tracks flows to funds.

FOREIGN FUNDS PERK UP. The first quarter of 1999 is a continuation of many of the same trends that have been in place for the last several years: Large-cap funds beat those that buy midcap stocks, and midcaps beat small; growth-stock funds beat value funds. The performance differential between the best and worst style-based categories is enormous--large-cap growth up 9.22% vs. small-cap value, down 9.02% (table), a gap of more than 18 percentage points. Last year, the large-growth to small-value gap was 42 percentage points, but that was over a whole year, not just one quarter. Fund returns are calculated for BUSINESS WEEK by Morningstar, Inc.

Funds that invest abroad, though lagging behind those investing at home, are doing a little better. Foreign funds, which invest abroad, are up 1.04% year to date. World funds, which can include U.S. stocks, are up 1.57%. Funds specializing in Japan jumped an average of 14.2%; Latin American funds, the worst-performing group in 1998, are up 9.03%, thanks to a surging stock market in Mexico. Diversified emerging-markets funds are up 6.33% year to date, giving their shareholders some hope that the worst is over.

No matter what category of fund you choose, the Internet trumps all. The simply named Internet Fund, which nearly tripled its investors' money in 1998, is racing ahead at a blistering pace this year--up an incredible 93.26% (table). Monument Internet Fund was close behind, at 90.87%. But the success of Net stocks reaches beyond the funds with Internet in the names. Fundmeister Garrett R. Van Wagoner engineered a spectacular comeback for his flagging fund family by piling into Net stocks. His flagship Van Wagoner Emerging Growth Fund is up a sizzling 54.7% year-to-date. Returns on four other Van Wagoner funds ranged from 31.86% to 58.29%.

BOND-FUND DOLDRUMS. What's also rising this year: interest rates. While the Federal Reserve seems satisfied enough to keep short-term rates at current levels, the bond market has sold off enough to push intermediate and long-term interest rates up about 0.60 percentage points. That has cut into bond fund returns. Long-term government bond funds, the most sensitive to changing rates, are down 4.22% for the quarter. Rydex Juno Fund, which moves in the opposite direction of bond prices, gained 6.59%, which made it one of the best-performing bond funds.

Still, the quarter was probably a draw for most bond-fund investors. Taxable bond funds are down 0.4% for the quarter. Tax-free funds, whose municipal-bond holdings are a little less rate-sensitive than U.S. government bonds found in the taxable funds, were up 0.31%. High-yield funds, in which improving credit quality of the bonds can offset some of the damage from rising rates, were up 1.98%. Emerging-markets bond funds, whose returns are also driven more by credit and liquidity than interest rates, gained 3.33%. That's not much of a bounce back considering the funds' 25.2% loss last year.

Investor appetite for mutual funds is still measured in billions of dollars a month. But even with the Baby Boomers' huge need to invest in equities to fund their golden years, fund inflows are falling. For the first two months of 1999, cash flows to equity funds were $17.9 billion, less than half the $38.1 billion registered in the first two months of 1998, according to the Investment Company Institute.

Some fund groups are actually losing assets. AMG's Adler says Franklin Templeton equity funds are particularly hard hit, with investors pulling out about $4.5 billion more than they put in during the first two months of the year. That's 5.25% of the group's equity fund assets at yearend. On the other hand, the Vanguard Group, the king of indexing, took in nearly $9 billion net cash into its equity funds during the same period.

Still, strong performance from managed funds can bring in the bucks. Adler says Janus Funds, many of whose funds have beat the S&P, took in $7.7 billion. That's more than twice what came in at Fidelity Investments, still the nation's No. 1, whose returns have been much improved over the last year.

Fidelity's flagship, the $85.9 billion Fidelity Magellan Fund, continues to outpace the S&P 500. Under Robert E. Stansky, it logged an 8.94% return for the quarter, handily beating the return on the next seven largest equity funds, including the 6.92% earned by the Vanguard 500 Index Fund (table). While all the largest funds are large-cap portfolios, Janus Fund and American Century Ultra Investors, which invest mainly in the large-cap stocks with the fastest growth rates and highest price-earning ratios, fared the best, up 12.42% and 11.46% respectively.

NET ALTERNATIVES. "Large-cap growth is still the place to be," says Robert Zuccaro, portfolio manager for the Grand Prix Fund, up 19.33% year-to-date atop last year's 111.8%. "It's the only segment that's worked for the last two years, and nothing I see is changing that." Zuccaro, a 30-year Wall Street veteran, says many fund managers have fallen behind the S&P because they won't buy something like Dell Computer at a price-earnings ratio of 80 or Warner-Lambert at 60 because it goes against everything they know. So they seek cheaper stocks, which don't go anywhere, or worse, go down in price. "Two-thirds of all stocks are actually lower today than they were at the beginning of the year," he says. "It must be the narrowest bull market ever."

If most fund managers can't swallow a large-cap stock selling for 80 times earnings, how do they get their arms around a Net stock with little revenue, no profits, and an ethereal valuation? Many opt for more established companies like Cisco Systems or Lucent Technologies, which build the equipment that make up the infrastructure of the Net. "Cisco is a beneficiary of the growth of the Internet, but who isn't?" says Ryan Jacob, portfolio manager of the $280 million Internet Fund, which has nearly doubled its shareholders' money this quarter. "I'd rather invest in Internet-centric companies." Jacob's fund zooms in on just 30 to 35 stocks, taking its largest positions in CMGI, Yahoo!, Doubleclick, and Ebay, and he's not overly concerned about bubble-like prices for his stocks. "Not with the trends in place like more people online, more time online, and more transactions online."

Still, Net-stock arithmetic proves vexing even to seasoned growth-stock investors like James L. Callinan, manager of Robertson Stephens Emerging Growth Fund A. "I thought we made out well when we sold Doubleclick at 100," says Callinan. "It's now 185." He has about 20% of his $610 million fund in Net stocks, and the ploy has paid off. The fund is up 24.18% so far this year, some 27 percentage points ahead of the average small-cap growth fund.

Aside from the Net stocks, it's hard to see much action in the beleaguered small-cap sector. The bounce these stocks got during the fourth quarter of 1998 evaporated this year, and the Russell 2000, the yardstick by which many small-cap funds are measured, is down 5.26% year-to-date. AMG's Adler estimates that investors have pulled some $8.5 billion out of small-cap funds so far this year, and managers have had little choice but to sell to meet redemptions. Callinan thinks the initial public offering market, by adding new supply at greatly inflated prices, is draining money away from already established small-cap stocks. Want to see damage in small caps? Just look at the worst performers. They include some onetime stars like Royce Micro-Cap Investors, down 14.97%, and PBHG Emerging Growth, down 14.74%--and that's just for the quarter. Many of the small-cap funds had negative returns for 1998 as well.

But before you despair, a reversal of fortune can come any time. For the past several years, European funds could do no wrong. Now several stand out on the worst returns list, dragged down by a slowing economy and sagging euro, the new Continental currency. European funds, in fact, are down an average 3.71% for the quarter. And while natural resources funds were bludgeoned last year, they're looking healthier now, up 8.78%, thanks to higher oil prices and stepped-up merger activity in the energy sector. Even the Lexington Troika Dialog Russia Fund is up 30.30% this year, after a horrid 83% loss last year.

Who knows? A few months from now the buzz in the fund world may be how the portfolio managers are beating the index funds.

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