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Return Of The Stock Pickers

Actively managed mutual funds are trouncing S&P index funds--and investor cash is pouring in

Return Of The Stock Pickers

For most of 1999, mutual-fund watchers--BUSINESS WEEK included--wondered if the funds' best days were behind them. Most highly paid fund managers had trailed cheap-to-operate index funds for years. And cash inflows to equity funds had also been trending downward for several years as investors sought zippier performance in other ways, such as online trading.

Then the mutual funds--riding the tech boom and Internet wave--built an incredible head of steam in the fourth quarter. That allowed dozens of funds to amass triple-digit returns for the year and enabled hundreds more to trounce the Standard & Poor's 500-stock index.

MOMENTUM. That changed everything. Once investors got a look at the yearend numbers, they started throwing money at funds faster than you can say E*Trade. They poured in some $40 billion in net new money in January and an estimated $60 billion--by far a one-month record--in February. "We're on our way to a $150 billion quarter," says fund analyst Avi Nachmany at Strategic Insight Inc. That's not much less than the equity funds took in for all of last year. "The momentum is incredible."

That momentum should keep up as long as fund investors are rewarded. And so far this year, the payoff is there. The average U.S. diversified equity fund gained 9.82% in the first quarter, including dividends and capital gains through Mar. 27. That's 2.5 times the S&P 500's return. International funds gained 4.9% for the quarter, while the EAFE Index, the major benchmark for global investing, was flat. The all-equity-fund average--which includes international and specialty funds--is impressive as well, up 8.25%. Mutual-fund performance data are prepared for BUSINESS WEEK by Morningstar Inc.

Returns from bond funds are also positive this quarter, thanks to falling long-term interest rates. Taxable funds earned an average 1.11% total return, and tax-free funds, 2.06% (table, page 198). Still, in the face of buoyant equity returns, no one cares about bond funds, and more money continues to flow out of them than comes in. The real bright spot in bond funds: convertible funds, which act a lot like equities. Convertible funds are up 12.87% for the quarter.

Instead of bond funds, investors seeking safety are opting for money-market funds. Money funds have picked up more than $100 billion in new cash this year. Money funds, which have virtually no principal risk, are yielding around 5.4%, and some observers think they'll hit 6% as the Federal Reserve keeps raising rates to slow the economy. That makes money funds tough competition for bond funds, where the net asset value can fluctuate.

Most of that mutual-fund cash is running toward the sort of funds that have already posted big returns. The biggest recipients are large-, mid-, and small-cap growth funds, technology funds, and international funds, all following last year's strong returns. That sets off another spurt of performance as managers put the new cash to work in the same Net, biotech, or Asian stocks that have worked so well for them.

A big chunk of this year's new cash is flowing into relatively few fund companies. That's not much different from last year. Fund-flow watcher Robert Adler of AMG Data Services in Arcata, Calif., says that over 40% of February's cash flow went to just four companies: Fidelity, Vanguard, Putnam, and Janus.

Janus Funds group, whose U.S. diversified funds earned an average 76.5% during 1999, is still pumping iron. Flagship Janus Fund is up 14.39%, the more concentrated Janus Twenty, 12.43%, and the globally diversified Janus Worldwide, 16.63%. Those three together have more than $125 billion.

"Conventional wisdom says big funds can't dance," says Edward S. Rosenbaum, director of research for Lipper Inc. "But they're dancing now." Indeed, it's not only the big Janus portfolios (table). The $37.6 billion Fidelity Growth Company Fund packed a 28.43% return so far this year, on top of last year's 79.5%.

Fidelity Investments is off to a running start. Jim Lowell, editor of Fidelity Investor, says some 50 Fidelity equity funds are beating the S&P 500. That's impressive, he adds, considering that 16 of Fidelity's 20 largest holdings are in the red this quarter. "They're getting that performance by moving below the large-cap belt into small- and mid-cap companies," says Lowell. "They're doing an amazing job picking stocks."

EXPERT HELP. Indeed, stock-picking is back in vogue. AMG's Adler says industrywide large-cap index funds--mainly S&P 500 funds--are getting only 4% of new cash this year, vs. 42% in '99. And that's not all. In four of the past five weeks, more money came out of index funds than went in. "The dollars going out are not large yet," says Adler. "But until now, there have never been two consecutive weeks of outflow, either."

No wonder Vanguard Group, the No. 2 fund company and premier purveyor of index funds, is also turning to stock-picking managers for help. Vanguard recently announced that TIP Funds' Turner Growth Equity Fund, up 20.3% this year and 40.7% in 1999, filed plans to reorganize as the Vanguard Growth Equity Fund. Vanguard also hired institutional investors Grantham, Mayo, Van Otterloo & Co. to launch the Vanguard U.S. Value Fund and take over a portion of the Vanguard Explorer Fund. "Vanguard needs some high-octane small-cap funds now that PrimeCap and Capital Opportunities are closed to new investors," says Daniel P. Wiener, editor of The Independent Adviser for Vanguard Funds. Indeed, many companies are shutting the doors to their best-performing funds to prevent all that money from swamping the managers' ability to invest it effectively.

Maybe Vanguard ought to look to its neighbor in the Philadelphia suburbs, PBHG Funds. The $28 billion fund group--which specializes in investing in high-growth, high-risk companies--is looking smart again after a few years in the doghouse.

This quarter's best and worst funds aren't much different from last year's (tables, pages 194, 196). Tech, biotech, and small-cap growth funds, which invest in tech and biotech, dominate the winners' list.

Although there are plenty of technology funds, not one of the top 50--and only one of the top 100--has "Internet" in its name. "An Internet fund is not really a tech fund," says Kevin Landis, a portfolio manager for FirstHand Funds, which placed four of its funds in the top 50. "Net funds end up owning a lot of dot-com companies, and they're trying to establish brand names, not technologies." Most Net-specific funds are up around 18% to 20% this year, well below the 32.32% average return for technology funds (table).

Health funds ran up more than 50% in the first two months of the year but took sick in March. Still, for the quarter, they're up 20.5%. The bug that felled them was a massive sell-off in biotech stocks after investors wrongly took comments by President Clinton to mean that the government opposed the patenting of human genes. Kurt von Emster, who runs Franklin Biotechnology Discovery Fund, takes the volatility in stride: "Sure, the industry is down 40% in the past three weeks, but we're still up 180% for the past 12 months."

The top performer for the quarter is Frontier Equity, a small-cap growth fund with a blistering 112.95% on top of last year's 149%. But don't put it on your buy list yet. It's a $2 million fund with a stiff 8% front-end load. Last year, expenses were 19.7% of assets, though portfolio manager James Fay says the fund is now large enough that the expense ratio should drop into single digits. Even with its recent rocket-like performance, Frontier Equity is the worst small-cap growth fund over the past five years, according to Morningstar. BUSINESS WEEK's Mutual Fund Scoreboard gives the fund an F, signifying poor risk-adjusted returns.

SEESAW. The quarter's No. 2 fund, Alpha Analytics Digital Future, up 68.65%, is also obscure. There's not much history to it, either, since the fund opened on Dec. 22 and has just $3.2 million in assets. This fund won't be weighed down by high expenses, however. Alpha Analytics Investment Group, the fund's manager, capped expenses at 1.3%.

It's not unusual for the strongest performers from one period to jump to the losers list in a subsequent period. Indeed, funds investing in Japan are doing just that. They're down 10.37% this quarter after a blistering 123.1% return last year. Weitz Hickory, a small-cap blend fund with an A rating from BUSINESS WEEK, is also in the loss column this quarter, down 14.88%. "There has been very little fundamental news on any of my companies that suggests they should go down," says portfolio manager Richard F. Lawson, who is sticking with his stocks. "They were cheap before, and they're even cheaper now."

Then there are value funds such as Oakmark I, Yacktman, and FPA Paramount, which invest in arguably cheap stocks that have been getting cheaper for years. Oakmark had $9 billion two years ago, but between portfolio losses and investors cashing out, it's down to less than $4 billion. So on Mar. 21, Oakmark replaced portfolio manager Robert J. Sanborn with William C. Nygren, who also runs Oakmark Select I, a value fund that has made money during the bear market for value stocks.

Actually, value-fund performance has picked up of late. Large-cap value funds were down nearly 9% in January and February, and they're now about even for the quarter. Perhaps that will stem the outflow of cash, but it's not yet strong enough to lure investors away from the high-flying growth funds.

See our mutual fund scoreboard at www.businessweek.com/investor/