Putting the Fun Back in Funds

Looks like a bull market. Equity mutual funds are earning double-digit returns, with some topping 50%

Look at your latest mutual fund report, and you may think you're in a time warp. U.S. equity funds are up a plump 14% so far this year. That's just ahead of the 13.2% runup of the Standard & Poor's 500-stock index. Technology funds have soared 24.9%. A few Internet and biotech funds are up over 50%. No, this isn't 1999, and you're not having a happy flashback. The bull market is back, at least for now, and fund managers are making up for lost time -- and lost dollars.

In some ways, this year has been even better than 1999 because almost every kind of fund has rallied: growth and value, large and small, junk bonds and Treasuries. But as in that storied year, growth stocks, especially technology and biotechnology issues, are leading the market.

Some ultra-aggressive funds with poor long-term performance, such as the Apex Mid Cap Growth Fund, are finally enjoying a day in the sun. Apex, which invests in volatile micro-cap stocks, fell 76% in 2000 and 42% more in 2002, yet it's this year's top performer, up 97.2%. Another risk-taker, ProFunds Internet UltraSector fund, uses leverage to capture 1.5 times the daily return of an Internet stock index. It has gained 76.0%. (Mutual fund returns are calculated by Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill (MHP ) Companies.)

Why are growth funds doing well? "Growth stocks are a scarce resource today, and that makes them very attractive," says Bill Miller, portfolio manager at Legg Mason Value Trust and Opportunity Trust, which this year are up 22.6% and 43.0%, respectively. Companies that can pay a decent dividend are also in demand since interest rates are so low and the tax on dividends has been slashed to the level of the capital-gains tax. So Miller has been investing in companies such as UnitedHealth Group, an insurer with 50% earnings growth over the past year, and Kodak, which has a 5.8% dividend yield that acts as a cushion if the market falters.

Most growth managers feel no need for cushions. Portfolio Manager Douglas Foreman's TCW Galileo Aggressive Growth Equities Fund is up 28.7% so far this year, on the backs of such Internet powerhouses as eBay (EBAY ), Amazon.com (AMZN ) and Yahoo! (YHOO ) The three have had tremendous runs, and he maintains that they are far from over. These companies can "grow their free cash flow 40% a year for the next three to five years," says Foreman. "Their stocks should go up as much."

SMALL-CAP POTENTIAL. Tech-fund managers are equally sanguine about the sector, but less so about its bellwether stocks. Wendell Laidley, who manages the top-performing RS Information Age Fund and RS Internet Age Fund, thinks the big Net stocks are played out. He's buying the smaller, "second-tier" stocks that he believes will have more upside potential as the economy improves. One favorite is DoubleClick (DCLK ) which is tied to online advertising, and Monster Worldwide, which is linked to the labor markets. Portfolio manager Jonathan Cohen of Royce Technology Value Fund (RYTVX ) looks for small tech companies that are light on debt and heavy on cash. Some of his holdings are NetRatings (NTRT ) which he calls the "Nielsen of the Web," and Verity (VRTY ), a database software company that is also gaining market share.

Will small-cap funds continue to shine in the second half? The value portion may lag going forward, if only because this fund sector did relatively well in the bear market. With a better economy, small-cap growth should prosper. "From a profit-potential perspective, smaller companies can ramp up production faster than larger companies during an economic recovery, " says Jim Oberweis Jr., co-manager of Oberweis Micro-Cap, up 40% so far this year. The stocks in his fund now have a median market capitalization of just $125 million.

Even with strong returns, portfolio manager Richard Gould of Rockland Small Cap Growth Fund (RKGRX ) is bullish. After three brutal years, he says, "my stocks are so cheap, they basically need a 100% gain to return to normal." Even though the earnings of his stocks are up 89% over the past year, his portfolio sells at a modest 17 times expected earnings for 2003 -- roughly the same as the overall market.

Value managers say they're having a tougher time. Jean-Marie Eveillard of First Eagle Global Fund, up 14.7% this year, says he can't find many bargains in the U.S. "It's easier to find cheap stocks in Europe," he says. "And it's even easier in Japan, which, after a 13-year bear market, has many bargains." Eveillard has loaded up on video-game maker Nintendo and property insurer Nipponkoa Insurance, which, he says, sell for close to the value of the cash on their balance sheets. That means investors are essentially getting the operating businesses for free.

Eveillard's fund is one of an exclusive club that has profited in both the bear market and in this year's recovery. Another, Hussman Strategic Growth F (und HSGFX )und, has gained 9.3% this year by removing a hedge against stocks in April. Portfolio manager John Hussman also thinks U.S. stocks are overpriced but factors stock-price momentum into his investment models as well as valuation. So when the market turned bullish, so did he. But, he cautions, "this is not a buy-and-hold-forever market." Traditional bear funds such as Prudent Bear (PBRCX ) and Rydex Ursa (RYURX ) which consistently bet against the market, are down sharply.

Foreign stock funds are in a different club. They've underperformed U.S. stock funds in both the bear market and in this year's upturn. They've delivered an average 12.4% return so far this year -- unimpressive if you consider that many major currencies have rallied sharply against the dollar. That should increase the value of foreign equities held by U.S. investors, but many foreign mutual funds, such as Tweedy, Browne Global Value, hedge their currency exposure so it doesn't have an impact on performance. Others, such as Oakmark International Fund, hedge selectively or not at all. So investors looking for a currency play should ask about a fund's hedging policy first.

Global managers are more skeptical than their domestic counterparts. "Since March, we've had sustained rallies in some of our most undervalued stocks, but we're walking on eggshells," says Sarah Ketterer, portfolio manager at Causeway International Value Fund (CIVVX ), up 17.3% this year. Indeed, U.S. economic growth is not strong, but Europe and Asia are even worse.

While stock fund managers suffered in the past three years, bond managers coasted on Easy Street. So far, this year has been more of the same for bonds, with the average bond fund up 5.9%. But well-regarded bond-fund managers such as PIMCO's Bill Gross and Loomis Sayles's Dan Fuss worry that the good times in bonds are coming to an end. Fuss, whose Loomis Sayles Bond Fund (LSBDX ) is up a hefty 20.6% this year, has cut all of the Treasury bonds from his portfolio because, he says, yields are now at 45-year lows and unlikely to go lower.

In the quest for yield, Fuss and other bond-fund managers are delving into riskier areas of the bond market. Fuss has a 35% weighting in high-yield bonds, which have credit ratings of BB or less. After a big rally in the sector, Fuss says many such bonds now trade at premiums to their face values, which can be "very dangerous for high-yield bonds." Since he is a bargain hunter, he buys bonds selling at a discount to face value, and he thinks these can earn 8% to 9% annual returns.

Another category that is scoring gains is emerging-market debt, up 23.5% this year. Still, portfolio manager Tom Cooper of GMO Emerging Country Debt Fund (GMCDX ) is bearish. Latin American debt, which accounts for a large portion of emerging-markets debt, "has rallied too far, too fast," he says. He still sees value in the bonds of such nations as Algeria, Jamaica, and the Philippines, but these countries are just small parts of the overall market.

If anything, the market's recent boom-and-bust experience teaches the perils of chasing past performance. So now might not be the time to delve into emerging-market debt, dot-com, or genomics funds just because they've soared. Still, growth-stock funds can invest in a broad array of companies and industries. After three brutal years, these funds may be in the early stages of a long recovery.

By Lewis Braham

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