Amid Turmoil, Funds Take Off

During the third quarter, equities rallied up a storm

Positive returns may be the one saving grace for mutual funds this year. State and federal regulators' probes of trading practices at such fund giants as Janus (JANSX ) and Nations Funds have mired the fund biz in its worst scandal in decades, but bull markets tend to sweep a lot of nastiness under the rug.

Across the board, equity funds have rallied, and bond funds have held their own despite a rise in interest rates. The average diversified U.S. stock fund is up 9.4% in the third quarter (through Sept. 19) and 24.1% this year, beating the Standard & Poor's 500-stock index's 6.7% and 19.2%, respectively. International stock funds have done even better, up 11.9% this quarter and 24.2% for the year, thanks to rallies overseas -- even in the long-suffering Japanese stock market.

Whether the bull market will last remains to be seen, but one thing is certain: Investors' appetite for risk has returned. In August, for instance, stock funds received $26 billion in new cash, the third-largest monthly inflow in three years. Meanwhile, all of the most volatile funds are topping performance charts. Even technology and emerging-market funds are back in vogue.

Those who flocked to blue chips with pristine balance sheets during the bear market are now betting that improving business conditions will lift the fortunes of smaller, weaker companies. "Lower-quality stocks of companies without earnings and higher debt have performed better than higher-quality ones this year," says John Montgomery, portfolio manager of Bridgeway Ultra Small Company Fund (BRSIX ). "That's typical during the early stages of an economic recovery."

Montgomery doesn't invest in debt-ridden or troubled companies, but he does buy tiny ones, which have a higher risk of failure but also a greater prospect for explosive returns than blue chips. Given investors' renewed predilection for risky fare, his fund has been a top performer, up 69.7% this year. So have a number of other small- and mid-cap funds, which continue to be popular with investors, receiving $8.3 billion in new money this August, according to fund tracker Lipper. Meanwhile, large-cap funds lost $900 million, while funds that invest in stocks of all sizes received $6.5 billion.

GROWTH IS BACK. Another sign of a bull market is the resurgence of growth funds, which are big investors in tech stocks. "We're doing well because we stayed the course," says Jim Oelschlager, manager of White Oak Growth Stock Fund. "When stocks such as Juniper Networks (JNPR ), Applied Materials (AMAT ), and Intel were getting pounded last year, we held on to them." His fund, which has 61% invested in tech stocks, is up 42% in 2003, vs. 21.6% for the average large-cap growth fund.

Tech-fund managers have a more discriminating view. "You can't just round up the usual suspects and buy them," says manager Kevin Landis of Firsthand Technology Value Fund (TVFQX ), which soared 32% this quarter. Landis is referring to big tech companies such as Oracle (ORCL ) and Sun Microsystems. He thinks there are attractive plays in the consumer-electronics and tech-consulting sectors. That's because consumers still want the latest in digital cameras, cell-phone cameras, MP3 players, and video games. As the U.S. government beefs up security in the post-September 11 world, IT consultants Caci International (CAI ) and Anteon (ANT ) have won lucrative long-term contracts, he adds.

One surprising rally is in precious metals funds, which were up an average 27% this quarter. Traditionally thought of as defensive investments, gold stocks and bullion typically zig when the market zags. Some gold-fund managers contend that the ongoing strength in the yellow metal is a sign that investors believe this bull market won't last and are trying to hedge their bets. "There are so many headwinds facing this economy," says Darko Kuzmanovic, manager of Scudder Gold & Precious Metals Fund (SCGDX ) up 46.7% this quarter. "Consumer and federal debt are at record levels, unemployment remains high, and the trade deficit is enormous."

Others, such as Caesar Bryan of Gabelli Gold Fund and John Hathaway of Tocqueville Gold Fund (TGLDX ), think the government's attempts to stave off deflation -- through interest-rate and tax cuts -- have created an environment that is good for gold and the stock market. Gold prices, like other commodities, usually rise with inflation. So the strong fiscal and monetary stimulus is a positive for gold investors.

OVERSEAS SURGE. Overseas, bull runs in Asia have buoyed foreign stock funds. The whole region has benefited from the consumer-driven recovery in the U.S., as it's the largest exporter of consumer electronics. Japan, in particular, seems to be awakening from its 13-year bear-market slumber. "A flood of stronger-than-expected earnings and economic data has been coming out of Japan this year," says George Greig, manager of William Blair International Growth Fund (WBIGX ) "What's primarily driving it is corporate restructuring." Manager Mark Headley of Matthews Japan Fund concedes that investors have a right to be skeptical after so many bad years. But he believes the recovery is for real this time. "Managers of Japanese companies are much more focused on profitability than they ever have been in the past," he says. "The old, inefficient system is dying."

The only disappointment this quarter has been bond funds. They've fallen 0.6%, on average, as interest rates have edged higher. And from the look of it, more bad news is coming. "A 4% yield on a 10-year Treasury bond will not be enough compensation for investors going forward if inflation picks up," says Tad Rivelle, chief investment officer at Metropolitan West Asset Management, which manages $14 billion in bonds. Bond funds saw $15.3 billion in shareholder sales this August, their largest monthly outflow in more than two decades. Apparently, fund investors agree with him.

Any indications that the economy is in full recovery mode will cause a further sell-off. So Rivelle is favoring high-yield bonds, which are yielding a more attractive 9% on average. But some managers say even high-yield bonds are no longer cheap. Manager Thomas Atteberry of FPA New Income Fund (FPNIX ) has been reducing his high-yield position and is currently 30% in cash.

One of the few bond funds to prosper this quarter is Rydex Juno (RYJUX ), up 6.1%. This unusual fund shorts, or bets against, Treasury bonds. Its assets have grown eightfold, to $800 million, since January. That's a good sign investors think there is more downside in bonds.

Still, most investors pin their hopes and aspirations on equities. As long as those funds are prospering, they can shrug off the decline in bonds.

By Lewis Braham

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