Follow The Raging Oil Bulls

Energy funds may head higher. But most stock and bond funds look earthbound

The winning strategy for fund investors this year can be summed up with a simple image: a big, black gusher of oil. Oil prices that raced from $40 a barrel to more than $55 carried funds focused on natural resources to an average total return of 10.9% for the first quarter, more than five times the gain of any other fund category. With strong global demand and most suppliers pumping flat out, the outperformance should continue as the year goes on.

Naturally, higher energy prices are weighing on the broad stock market. And so is the specter of higher inflation -- and higher interest rates. The Federal Reserve recently hinted that there may be a longer cycle of rate hikes than many market participants had expected. That signal also removes any remaining allure of bonds as a refuge: For the past several years exposure to bonds helped offset down days in the stock market. But lately bonds haven't provided much ballast: While investors in U.S. diversified equity funds saw not a dribble of a return as their funds fell an average 3%, the average bond fund also showed a loss, down 0.9%. (Fund data are for the first quarter through Mar. 28. They're calculated by Standard & Poor's, which, like BusinessWeek, is a part of The McGraw-Hill Companies (MHP ).)

Can the strength in natural resources last? Absolutely, insists raging oil bull Kenneth Heebner, who had three of his four Capital Growth Management funds among the quarter's top 100 funds. Energy investments helped drive the $1.1 billion CGM Focus fund up 10.1%. The case for continued gains: "Demand growth in China isn't slowing down," Heebner says, "and there's accelerating demand from India and other parts of Asia." Leigh Goehring, whose $655 million Jennison Natural Resources (PGNAX ) fund rose 9.8%, is also gung ho on energy. His 65% weighting in oil is the highest it has been in his 13 years at the fund.

While Heebner's top holdings include large caps such as Amerada Hess (AHC ), Goehring focuses on companies with projects in the Canadian oil sands. There, the high-cost process of extracting bitumen out of oil sands has become more economical as oil prices have risen. His favorite pick in the sector is Opti Canada. (His fund was a backer of the company when it was private.) He also likes Canada's Suncor Energy (SU ). "Companies with access to long-lived, robust reserves will be the winners," says Goehring. "For practical purposes there are unlimited reserves in the oil sands, and these companies are still cheap."

What's also cheap -- and getting cheaper every day -- are growth stocks and the funds that invest in them. Large-cap growth funds lost 4.3% since January, and small-caps dropped 5.1%, dragged down, in part, by their tottering technology holdings. Tech is one area where aggressive investors should venture, says James Paulsen, chief investment strategist for Wells Capital Management. "When investor sentiment improves, tech will be one of the first sectors to benefit."

As the U.S. stock market struggled, returns were better, but hardly stellar, abroad. Diversified emerging markets funds were up 0.8% and those specializing in Asia (ex-Japan) gained the most, up 1.7%. And more U.S. investors are seeking opportunities overseas. According to research firm Strategic Insight, international equity funds captured $40 billion of assets in the first quarter, almost half of the net inflows into all equity funds.


Some global funds are finding success in unusual places. The $321 million T. Rowe Price Emerging Europe & Mediterranean Fund (TREMX ) credits much of its 9% gain to its stake in Egypt. There, a new cabinet is instituting structural economic reforms, such as slashing personal income-tax rates. "By emerging market standards, top-tier Egyptian corporations are good quality," says Todd Henry, an emerging-markets portfolio specialist at T. Rowe Price (TROW ). "We think reform momentum will continue."

Investors waiting for the U.S. stock market to sort itself out won't find many opportunities in bond funds. The high-yield municipal category gained 0.8%, but aside from a 0.04% return for ultrashort bonds, all other categories of bond funds were down. With interest rates heading higher, the challenge to bond investors is pretty cut-and-dried, says Kenneth Buntrock, manager of the $1.1 billion Loomis Sayles Global Bond Fund (LSGLX ): "What do you do in a bond bear market?"

One option is to seek better returns outside the U.S. But one of the most popular global bond fund categories -- emerging markets -- is in a pullback. After a 6.3% gain in 2004's fourth quarter, down from 9.2% the previous quarter, emerging-markets bond funds fell 2.5% in the first three months of 2005.

Another approach is to buy funds that invest in foreign currency bonds, looking to benefit from a falling dollar -- but you can't count on that. In fact, in the wake of the Fed's recent rate hikes, the dollar has strengthened against the euro and the yen.

That sends bond investors back home. One approach to rising rates is to "shorten up" -- buy bonds or bond funds with short maturities. Those bonds will mature in a couple of years. The yields are lower than intermediate and long-term bonds, but the value is less affected by higher rates. The shortest-maturity funds, of course, are money market funds. The average maturity of the securities in money funds is less than 90 days. Right now the average taxable money fund yields about 2%. The advantage is that you're not locking in still-low yields, and money-fund returns will rise as the Fed lifts rates.

A less traditional short-term play is a bank-loan fund (also called a prime-rate fund). Such funds invest in floating-rate bank loans -- and the yields adjust along with short-term rates. Because the credit ratings on the loans are below investment grade, the yields are typically higher -- more than two percentage points above the London interbank offered rate (LIBOR), which is now 3.1%. The rub: Some funds have expenses as high as 1.5%. And according to Morningstar, Fidelity Floating Rate High Income Fund (FFRHX ) is the only no-load offering.

In coming months the investing climate will be challenging as the markets are buffeted by economic crosswinds. If stuffing money under the mattress starts to seem like a wise move, remember that the smartest strategy is often contrarian. "For the last two years people have said that the stock market was going to die," says Wells's Paulsen."As long as people keep saying it's over, it ain't."

By Suzanne Woolley

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