Mutual Funds: Smaller Is Better Now

Small- and midcap growth funds show the most promise, says BW's Mara Der Hovanesian

If the economy and the market are indeed at or near the bottom, as many analysts say, mutual-fund investors should think small. So says Mara Der Hovanesian, markets and investments editor of BusinessWeek, who tracks funds for the magazine. Small-cap and mid-cap funds tend to do better coming out of a slump, she notes.

Large-cap growth funds have taken a hit in recent month. This has shifted the accent to funds using the value strategy. But looking ahead, Der Hovanesian says growth funds may be the place to look once again -- though in the small and midsize area, and not necessarily in technology, the latter-day star.

In BW's report on first-quarter fund performance, the best showings came from so-called bear funds, which short stocks. But Der Hovanesian cautions that because of their risk, such funds should be only a small part of a portfolio.

These observations came in a chat presented on Apr. 17 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from the chat. A full transcript is available on AOL at keyword: BW Talk.

Q: Before we delve into mutual funds, Mara, the market has looked a bit better (depending on the day). What's your current diagnosis -- and prognosis?

A: ...I'm probably in the dark as much as anybody else, but the consensus is that we're rolling out of a bottom -- though in fits and starts.

Q: With the first-quarter results in, did any type of mutual funds do better than the market generally?

A: Funds that short the market did the best, followed by a select group of small- and midcap value funds. Potomac Internet Short Fund gained 30%, as did Pro Funds' Ultra Bear -- they were up 23%. But longstanding performers, such as some Longleaf and Heartland value funds, outperformed.

Q: But aren't "short" funds pretty risky for the average investor?


Yes. I wouldn't recommend moving your retirement portfolio into bear funds. But a little cushion in them helps to balance out losses in more mainstream, diversified funds.

Q: What do you think about American Funds' Growth Fund of America?

A: It's one of the biggest stock funds in the country, and it's down 11% in the first quarter. It's sort of lumbering under the same large-cap growth issue that the rest of the market is under.

Q: Should I invest any more into Growth Fund of America, or sit and wait for the market to level out?


I don't feel comfortable advising investors what to buy and what to sell. I can tell you how it's performed and what the risks may be.... My sources tell me that in a recovery, a market and economy tend to support the performance of smaller and midcap stocks -- and growth-oriented funds, incidentally, not necessarily value. And the caveat is that "growth" isn't necessarily what we thought it was in the '90s either -- i.e., technology. Others could include energy and leisure/media.

Q: What about Ameristock fund?

A: It's another large-cap value fund. It has a decent long-term record and a longstanding manager. The fund is also known for taking low levels of risk, but a heavy weighting in financials could continue to drag it down this year.

Q: Fidelity Select Electronics -- is it time to move?

A: Those Fidelity Select funds are so thinly sliced that it really depends on an individual's portfolio. You have to look at how much technology you have overall, and if that's the only technology exposure, then maybe not. There were some fund manager departures at Fidelity recently -- you'd have to check and see whether Hanson of that fund left. If that's the case, it may be a good reason to leave.

But I'd like to caution this: Investors should make sure that they're not just dumping funds indiscriminately because they're down and out. By the way, analysts are on the fence regarding where we are in the cycle for semiconductor issues, and this fund invests mainly in semiconductor issues, so you have to figure out where we are in the cycle or whom to believe.

Q: Adding to that question, are any sector funds doing well now -- or which are doing less badly?


None of the category averages in the first quarter turned in positive results. Tech, as you'd expect, was the worst, at a 25.7% negative return. This quarter, even value funds of all stripes -- the so-called conservative investing style -- were also in the red. Fund sectors that performed better than the market -- though still underwater -- included small-cap value, down 0.33%, and real estate funds, down 1.15%.

Q: What do you think about Vanguard's Windsor II?

A: One of the better mammoth funds. It's recently turned around performance, but it's still down 3% for the first quarter. It's not one of the best large-cap value funds around, though, based on past performance. It's in the 23rd percentile, year to date, so it could be better.

Q: What about Janus Worldwide?

A: The fund's been in trouble for two years. It has lost more than the market and the peer group. The manager has a halfway decent long-term record. I talked with the manager, Helen Young Hayes, and she doesn't tend to turn over her stocks, so if you feel comfortable hanging onto Cisco (CSCO), Citigroup (C), Nokia (NOK), then stick with the fund.

Q: Health care is a sector many analysts like -- what do you think about Vanguard's health fund?

A: It's from Vanguard, so it's a low-cost option. It's a diversified fund that doesn't load up on either risky biotechs or a lot of large-cap drug stocks. So if you're an investor who likes a low-key approach, it's a decent choice.

Q: This must be a time of real testing for fund managers. Have you spotted any especially good performers as managers?


Yes, a handful. And most of them have weathered downturns in the market before. Take, for instance, Paul Wick of the Seligman Communications & Information fund. He has been able to beat his tech peers by a long shot. The fund has been around for about 10 years, and he's about 27% ahead of the average tech fund, even though he's down 8% or so. On the other hand, there are people like Bill Nygren who are turning out their best gains ever -- something like 8% so far this year. Not bad in a market that's down more than 10%. He's with Oakmark funds.

Q: Do you think a midcap fund is good for three to five years?


Funds that invest in small- and midcap stocks are expected to outperform for, say, the next 12 to 18 months, and that's as far out as I've heard analysts and managers willing to go.

Q: And specifically for names, what do you see in midcap growth funds?


What I can provide are the funds that have done well in the first quarter this year, some of which are long-term performers. Those include Berger Mid-Cap Value fund, up about 5%; Apex Mid-Cap Growth fund, up 9%; Franklin Micro-Cap Value, up 12.3%; and Dreyfus Mid-Cap Value, up 11.2%. Dreyfus also has a Small Company Value fund, up 17% in the first quarter.

Q: Your thoughts on Babson Value fund?

A: It's a really strong long-term performer. Even though it's down about 1% this year, it's got trailing one-year returns of about 17%. The biggest problem is that one of its longtime managers left. But it seems to have gotten over that hurdle.

Q: What about the Total Stock Market Index fund?

A: it's really the best bet to ensure that you're going to keep pace with the market, and I happen to be of the thinking that it's better than an S&P 500 fund, which is cap-weighted. It's more representative of what's happening. And if you believe that passive investing is superior, it's a good place around which to build your core portfolio.

Q: How do you suggest an investor go about picking funds now? The waters look treacherous -- any navigational tips?


Navigational tips? The first thing is to check if your tolerance for risk has been shaken. A lot of money managers are saying that they're buying heavily a lot of things that have been beaten down because they see more potential upside. But it's not going to be a straight line, so first check your tolerance for risk.

Whatever you invest in, it may go down from here. Nobody can tell where the bottom is. So do your homework, find low-cost funds, be diversified, and dollar-cost average. And probably a good thing is to stay away from the obvious trainwrecks, like Internet funds and highly speculative sector funds.

Q: Mara, can you come to any general conclusions about fund families and their relative performance now?


No! Not anymore! In the last seven years it's been very clear who the winners were. But the flows and performance are more spread out now, which makes it important for investors to look at long-term track records and go with managers and fund companies that have broad offerings and have worked through different market cycles.

Edited by Jack Dierdorff

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