Mutual Funds: A Year Upside Down

Low-key value and muni-bond funds look great

During the latter half of the 1990s, mutual-fund investors might have gotten the impression that fat, double-digit returns were an entitlement. This year shattered that belief. Higher interest rates, slower economic growth, and a bear market for tech stocks resulted in the most disappointing year for fund investors since 1994. All told, equity mutual funds fell an average 2.37%, while U.S.-only funds eked out a scant 0.46% total return (appreciation plus reinvestment of dividends and capital gains through Dec. 8). Mutual-fund data were prepared for BUSINESS WEEK by Standard & Poor's Corp.

The funds that fell the hardest were the superstars of yesteryear--large-cap growth portfolios like Janus Twenty Fund and Internet plays like Munder NetNet. In contrast, value-fund returns--and value managers' spirits--have revived. "The darlings of last year are the dogs of this year," says David Winters, co-manager of Franklin Templeton's Mutual Beacon Fund, a large-cap value fund up 12%.

Not that the new darlings are all that impressive. Large-cap value funds, up 4.63%, earned less than the average money-market fund. Small-cap and mid-cap value funds were virtually tied at 11.80% and 11.76% respectively. Still, all three value categories left their growth counterparts in the dust: Large-cap growth funds shed 6.71%, small-caps dropped 4.61%, and mid-caps managed a slim 1.80% gain (table, page 126).

That's sweet revenge for managers such as Edward T. Shadek Jr. His $375 million Putnam Small Cap Value Fund earned a respectable 18.53% return, buying companies with low price-earnings ratios, such as Bindley Western Industries, a drug distributor, and Bank United Corp., a Texas thrift. A year ago, he was virtually ignored in the company lunchroom and, says Shadek, "no one cared that we owned solid companies in decent businesses with good cash flows." Today, his colleagues are constantly seeking him out for investment advice.

The comeback of value funds isn't the only thing that has turned 1999 on its head. Boring old taxable money-market funds, up 5.18%, and tax-free money funds, up 3.13%, handily outclassed stock funds. Among specialized equity funds, Old Economy stalwarts like financial services, up 23.71%, and real estate, up 21.09%, trounced New Economy tech and telecom portfolios, down 20.85% and 24.02%, respectively.

Many sorts of bond funds outdistanced equities. The average tax-free bond gained 8.47%, while taxable funds posted 4.74% (table, page 126). A flight to safety and a U.S. Treasury buyback led to 11.75% gains in long-term government bond funds. High-yield bond funds, hit by deteriorating credit quality and rising defaults, were down 9.73%.

WORST SECTOR. And what of those 300-odd wonders--mostly Internet, tech, and Japanese funds--that racked up 100% to 500% gains last year? Only a handful are in the black for 2000, and most barely at that. Funds that invest in Japan, which posted 120% gains in 1999, now rank as the year's worst sector, down 32.77% on average. Corporate restructuring in Japan just hasn't gone far enough to revive the country's sluggish economy.

One of the best ways to play the tech sector in 2000 was to bet against it. Turns out, the Potomac Fund's Internet/Short Fund gained 23% by betting that the Dow Jones Internet Index was heading south. Still, ICON Information Tech Fund, which is long stocks, did nearly as well, up 19.43%. Its secret: invest only in tech companies with earnings.

As for Internet-specific funds, the market made mincemeat of them all. The most battered was Jacob Internet Fund, which only got started about a year ago. The now $63 million fund lost 72.57% in its first year--the second-worst of all equity funds (table). That was a comeuppance for portfolio manager Ryan Jacob, who in 1998 and 1999 led the Kinetics Internet Fund to gains of 196% and 216%, respectively.

It was also a year when some little-known funds had their day. Consider the Oppenheimer Real Asset Fund, a natural resource fund launched in 1997. "It came out at the wrong time and just went straight down for a year and a half," says co-manager John S. Kowalik. The fund is up 43.92% this year, more than twice the return of the average natural resource fund, and among the top 50 of all equity funds (table, page 124). The Oppenheimer fund has different results because it invests in commodity-linked bonds and futures and forward contracts rather than the stocks of oil and other natural-resource companies. Kowalik says the fund's unique approach "is beginning to prove its case."

Health-care funds, boosted by the booming biotech sector, are also in the winner's circle, with gains of 50.89%. Half of the 50 best-performing funds came from this category. One of the two funds with triple-digit returns is the Evergreen Health Care Fund, run by Lui-Er Chen, who is also a physician. The year-old, 85-stock fund invests in six different health-care sectors, including distributors and services. A third of its $60 million in assets are in its top 10 holdings, which include heavyweights Genentech Inc. and Pfizer Inc. Chen's not sure he can replicate the fund's 117.84% return, but he's confident the sector's supercharged performance isn't a flash in the pan like last year's Internet runup. He shrugs off the threat of government-imposed drug price controls and cites aging demographics and a strong demand for biotech products that treat cancer and rare diseases.

Bigger was not better this year. Six of the 10 largest equity mutual funds lost money (table, page 125). That includes the $104.4 billion Vanguard 500 Index, down 5.70%--its first negative performance in a decade. Similarly, the $101.6 billion Fidelity Magellan Fund clocked in its first losses since 1994. Whatever success stories there were among the big funds belonged to value managers: Vanguard Windsor II, which lost 6% in 1999, climbed 12.39% this year.

The turmoil in the equity markets sent many investors fleeing to bonds for the first time in years--and municipal bond funds turned up their best returns since 1997. The strong Treasury market helped munis, but that was not all. New issues fell to $185 billion from $225 billion in 1999, and the shrinkage in supply hit the market just when demand was picking up.

BIGGEST RISK. Investors haven't yet shown any interest in high-yield bond funds, which had their worst year since 1990. They're an opportunity if you're a contrarian, contends Jeffrey L. Rippey, co-manager of $460 million in high-yield assets for Columbia Funds Management Co. "Our expectations will be, simply, a soft landing" for the economy, says Rippey, who has been adding beaten-down telecom bonds such as McLeodUSA Inc. and Level 3 Communications Inc. to his portfolio. Stakes in the more stable gaming and energy sectors have helped to smooth out some bumps along the way, he says. He says the biggest risk for high-yield investors in 2001 is that the Fed won't further ease interest rates, causing the capital markets to clamp up, prompting even more defaults.

That dire scenario isn't likely, say most fund managers. Still, even if the economic soft landing comes to pass, most fund managers believe the new decade will have more modest returns than the old one. They expect the stock market to deliver returns of 7% to 15% for the next several years, which is more like the average annual returns earned before the late 1990s' frenzy. Says John G. Goode, 10-year veteran manager of $2.3 billion Smith Barney Fundamental Value Fund: "We're getting back to the real world."

    Before it's here, it's on the Bloomberg Terminal.