06/17/96 THE YEAR OF BIG MONEY AND SMALL FUNDS

THE YEAR OF BIG MONEY AND SMALL FUNDS
Cash is rushing in at twice last year's rate-and it favors aggressive investments
If investors love stocks, they're absolutely mad about mutual funds. So far this year, they have poured more than an estimated $115 billion into stock funds. That's almost as much as they invested in all of last year. And if positive reinforcement means anything, they will keep money flooding in. Equity funds have posted returns of 12% (appreciation plus reinvestment of dividends and capital gains through May 31) vs. 9.67% for the Standard & Poor's 500-stock index.
Of course, even with the strong start, no one expects funds to duplicate their 30%-plus gains of 1995. But in some respects, funds are doing even better this year. In 1995, the large-cap stocks that dominate the S&P 500 soared, leaving most funds--which tend to buy smaller-capitalization issues than are in the S&P 500--struggling to keep up. This year, the returns of large-cap stocks are good, but those of smaller issues are even better. That's why the average fund is beating the major market averages hands down. Funds investing in small-company stocks have posted total average returns of 19.61%--more than twice the return at this point in 1995. Maximum-growth stock funds, which often invest in small companies, are also on a tear, logging an 18.26% return.
Investors who think small when investing abroad are also doing well. Diversified emerging-market funds--the sort of funds that blend investments in the nascent markets of Latin America, Asia, and Europe--are looking good this year, up 14.42%. These markets and funds are just emerging out of a two-year bear market, and most analysts think the stocks still make compelling plays (page 104). The more staid foreign stock funds, which invest in the more mature markets, are up 8.56%.
All told, most equity funds are delivering the goods. In 22 categories of funds, all have positive returns--12 in the double digits. Technology funds, which ran red in the first quarter, bounced back in the second and are now up 13.01% for the year. Among the specialized funds, precious metals, up 32.87%, and natural resources, up 19.1%, are making the best showings.
Some investors might feel uncomfortable about that, figuring such numbers are harbingers of higher inflation. No doubt, higher prices for natural resources are a concern, but they also pose an opportunity (page 102). Gold funds, however, aren't getting any lift from the metal itself. Gold is no higher today than it was at yearend 1995. What's driving the stocks in the funds are some big gold strikes by small companies. As a result, investors are crowding into a relatively small market sector. ``By every valuation measure, most gold stocks look pricey,'' says Victor Flores, who runs two gold funds for United Services Advisors Inc. ``The prices for some companies discount gold strikes that have yet to be made.''
BONDS SUFFER. The worst performers among the equity funds were utility funds, up only 1.02%, bloodied by rising interest rates. Other yield-sensitive sorts, such as asset allocation, balanced, and equity-income funds, were subpar performers as well. An ill-timed bond investment crimped returns at the giant Fidelity Magellan Fund (table). It's up a scant 2.91% so far this year. Still, even the most sluggish equity funds outpaced bond funds.
With long-term interest rates up one percentage point this year, bond funds are in a funk. Taxable funds are down an average 0.58% in total return; tax-free funds, a little worse, down 1.88%. The only sectors that are solidly positive for 1996 so far are convertible bond funds, with 8.14% returns, and high-yield corporate funds, with 4.59%. The strength in those two sectors should come as no surprise: They're the two most closely linked to the stock market, and rising stock prices offset a portion of the damage of higher interest rates. International bond funds also were slightly on the plus side at 1.82%; short-term world income funds, up 2.19%.
Some investors think this year's rate rise gave small-cap stocks and funds a boost. ``Last year, the S&P 500 had 19% earnings gains and falling interest rates, and that's tough to beat,'' says Louis G. Navellier, a newsletter writer and fund manager. ``This year, the S&P stocks may post a 7%-to-9% earnings gains, and rates are rising. So money managers have shifted to smaller stocks because the earnings prospects are much, much better.'' His funds, Navellier Aggressive Growth and Navellier Aggressive Small Cap Equity funds, are up 40.54% and 38.87%, respectively.
Mutual-fund investors are also making that switch to the smaller- and medium-cap companies. Robert Adler, whose AMG Data Services in Arcata, Calif., tracks money flowing in and out of funds, says about half the $4.4 billion a week flowing into equity funds now is going into the most aggressive, risk-taking funds. At this time last year, only 15% of money was headed that way. Adler says the more conservative equity funds, which invest in larger-cap stocks, are now getting only about 15% of the cash flow vs. about half in mid-1995. This flip-flop in cash flows has another dimension. The more aggressive funds are getting a bigger share of a bigger pie: Adler says overall flows are about twice those of 1995.
Some market mavens point to the sizzling small caps, the red-hot market for initial public offerings, and the fund investors' insatiable demand for riskier funds as sure signs of a market about to blow up. But small-cap specialists say that these issues have underperformed the big stocks for two years, and relative to the valuations of the larger stocks, they're playing catch-up.
Likewise, those who invest in the IPO market say the trick is separating the solid deals from the froth. ``If you work hard at research, you can find great long-term investments,'' says Michael L. Schonberg, portfolio manager of the Dreyfus Aggressive Growth Fund, which, up 67.61%, is the No.3 fund for the quarter. One of Schonberg's winning IPOs is Fuisz Technologies Ltd., which makes drug-delivery systems. Fuisz went public in December at $8, finished 1995 at $10, and now sells for $27. Unlike managers who must invest in small caps, Schonberg says he's in those stocks by choice. ``I could buy IBM, or I could raise cash if I wanted to.''
SMALL PONDS. Even among the small-company funds, there's a tiering of returns. Some of the best numbers posted thus far belong to ``micro-cap'' funds, the smallest of the small, usually defined as stocks under $100 million in market capitalization. It's in this corner of the market that the billions have the most impact. ``I've heard more about micro-cap investing in the last year than in the last six,'' says James ``Chip'' Roberts, co-manager of Oberweis Micro-Cap Fund, up 48.80%.
To keep from getting swamped by the torrents of cash, many small- and micro-cap managers have been closing their funds to new investors. Oberweis Micro-Cap went one step further. On May 22, when the fund hit $50 million in assets, it stopped taking money even from its existing shareholders.
With successful new funds shutting their doors so soon, investors are put in a quandary. The conventional wisdom suggests investors not rush headlong into a new fund. ``If it's a new fund run by a manager who already has a track record, you don't have to wait,'' says Russel Kinnel, equity fund analyst at Morningstar Inc. That seems to be the case with Garrett R. Van Wagoner, a portfolio manager with a red-hot record who opened his own fund company in January. His three funds together already have more than $1 billion in assets.
On the bond fund side, investors pretty much know what they're getting as long as they pay attention to interest rates: They're getting hosed. Government bond funds, those most sensitive to changes in rates, have had a -2.06% return so far this year. That means declines in bond prices are greater than the funds' interest income. Corporate funds are faring a little better, since a stronger economy, which is what is souring the bond market, improves the credit quality and prices for many issues. Some of the best returns come from emerging-markets debt funds, which, like their equity counterparts, are now on the rebound from a disastrous two years.
On the tax-free side, some of the best returns come from small muni funds specializing in the bonds of small states: North Dakota, South Dakota, and Montana. These funds rose to the top because they didn't fall as much as their competitors, thanks to some hedging in the bond futures market, says portfolio manager W. Dan Korgel, who runs these funds. Perhaps it's just another sign that in 1996 at least, mutual fund investors should think small.

By Jeffrey M. Laderman in New York