Tiptoeing Back into Mutual Funds

Investors--and managers--are cautiously optimistic

Small gains, less pain. It's not much, but it's something mutual-fund investors can be grateful for these days. Despite the early March stock market rally, the average U.S. equity fund ended up where it began the year three months ago--a big comedown from the previous quarter's 14.8% surge. Microscopic as the less-than-1% gain may be, it's a darned sight better than the beating investors took a year ago: a 13% decline that turned out to be the prelude to a lousy year. "It has basically stopped getting worse," says Dan Veru, portfolio manager of $1.2 billion in small-cap value assets, including the GE Small Cap Value Equity Fund.

When is it finally going to get better? Good question. For now, the market skeptics still preside. Fearful of worldwide economic turmoil, gold bugs flocked to precious-metals funds, which are up 30% and the best-performing group. Sure, there are some unusual stock fund standouts this quarter: The No. 1 American Heritage Fund and the No. 7 Frontier Equity Fund are perennial losers run by managers with a taste for risk. The American Heritage Fund, up a gargantuan 75% for the quarter through Mar. 22, for instance, has lost 30% a year on average since 1998.

The good news is that as the economy starts to recover, the reign of worrywarts may be ending. Short funds, regulars among top-performing funds for the past 18 months, are conspicuously absent this year. And investors are more upbeat: The estimated $60 billion of net inflows into equity funds in the first quarter is the largest in two years, according to Strategic Insight, a New York research firm. Scanty bank-deposit and money-market yields, which sank to record lows in March, are driving increasingly confident investors back into mutual funds.

Fund managers, too, are confident they can beat the market averages this year. But their optimism is still tinged with caution: Many hold a lot of cash as a hedge against sudden market declines. Others are sticking to Old Economy favorites or cash-rich companies with squeaky clean balance sheets. These are cushions smart managers are using "just in case we're not out of the woods," says John Carey, fund manager for the $7.23 billion Pioneer Fund. The fund is up 3% this year thanks to Carey's penchant for buying investments in dividend-paying stocks such as Alcoa, PPG Industries, and General Motors.

The measured approach to stock-picking will likely continue to favor value stocks for the rest of the year. Although their two-year runup has narrowed the valuation gap between them and growth stocks, they're still edging out the competition. Small-cap value funds, for instance, have gained 6.3% so far this year, the best performance among diversified equity funds. Normally, growth funds would begin to take center stage at the start of an economic recovery. Why isn't this happening yet? Rosanne Pane, director and mutual-fund strategist at Standard & Poor's, says it's because of what she calls "new-value" managers--a rising class of stock-picker with a more "pragmatic" style. "They don't just buy stocks because they're cheap," says Pane. "They buy them because they see some catalyst that will make the stock grow."

Their strategy aims to find dynamic companies in otherwise stodgy industries. For example, co-manager Gail Bardin, of the $35 million Hotchkis and Wiley Large Cap Value fund, favors insurance and health care. Despite the recent economic weakness, both sectors have instead enjoyed rising demand and the freedom to raise prices. The fund's top 10 holdings include Allstate and Metropolitan Life Insurance, which contributed in part to a 6% gain so far this year. "The key is having low expectations," she says. "It's that basic."

Small-cap funds are still crushing larger cap funds, too. Inundated by torrents of new cash, many small-cap managers have closed their funds to new investors to preserve their solid returns. The Columbia Small Cap, Wasatch Small Cap Growth, and MainStay Small Cap Value funds, among others, have recently shut their doors. It's no surprise that small companies tend to perform well in the early part of a recovery. But many managers believe that if the recovery is sluggish, this stage of the cycle--and their time in the sun--could be more prolonged than usual. Also, a meager calendar for initial public offerings will spotlight small firms that are thriving now. "There are so many existing small companies that have been beaten down," says Michael Balkin, who manages $200 million in small-cap stocks for William Blair & Co. "We'd rather focus on them."

Technology funds have been battered, losing 7.5% on average in the last three months, vs. a heady 36% gain in the preceding quarter. That makes them the second-worst group this year, behind telecom funds, which were down 14.5%. Tech proponents say there are survivors among the carnage of the first quarter: Semiconductor companies are up almost 60% since the broad market bottomed on Sept. 21. "Semiconductors are the first to lead," followed by other tech sectors some 18 months later, explains Robert Turner, chief investment officer of Turner Investment Partners in Berwyn, Pa., which manages $9 billion of equities, 30% of it in tech. "It's not going to be straight up, but the bias is in the right direction."

Biotechs are in the tank, too. The sector has made attempts to rally, but returns to the same bottom. Diehards insist it's only a matter of time before the industry busts loose: Liana Moussatos, manager of $400 million in biotech assets for UBS Global Asset Management, notes that biotechs raised $33 billion in 2000, more than they did in the previous decade. Well-capitalized companies such as Celera Genomics Group and Human Genome Sciences "are sitting pretty," she says.

So, for that matter, are emerging-market funds, which soared nearly 12% on average in the latest quarter. Managers such as Arjun Divecha, lead manager of the $1.7 billion GMO Emerging Markets Fund III, like to minimize their risks by focusing on countries where local demand for industrial materials and consumer durables is accelerating. His fund is up 19.7% so far this year, driven by investments in Thailand, Indonesia, the Philippines, and Russia. Many emerging countries have learned lessons from the financial debacle of 1998 and responded by lowering their debt and improving corporate governance. "They're much more friendly to minority shareholders," adds Divecha. "They realize that when you are trading at five times earnings, the way you get rich is by paying dividends, putting foreigners on your board, and being transparent."

By contrast, bond funds have dwindled after two years in the limelight. So far this year, the average taxable bond fund is down .02%. Last year, bonds with a short duration rallied as the Federal Reserve cut rates. But, says PIMCO muni-bond manager Mark V. McCray, who runs $4 billion in muni bonds, "with the Fed on hold or tightening, that is likely to be reversed to a degree." Some high-yield bond funds have been an exception, though the sector is littered with minefields left primarily by the telecom industry. Observers say investors aren't yet getting paid enough to take on the market risk. For those with the nerve, Gary Arne, managing director of S&P'S Advisor Services, recommends offerings from the Janus and T. Rowe Price groups, both up more than 2% this year. Says Arne: "They have larger credit staffs and experienced managers."

Most investors haven't had a big appetite for risk. And they aren't likely to get it back until the market and their mutual funds keep moving in the right direction, even if it is only 1% at a time.

By Mara Der Hovanesian

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