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THESE UNDERDOGS FUNDS WILL HAVE THEIR DAY

Comebacks are overdue in small-cap, international, and ''value'' funds

It's been a wild and sometimes trying year for mutual-fund investors. But those who have stuck by their funds are earning sweet returns. The average U.S. diversified equity fund logged a 17.30% total return. Toss in the specialty funds and the international funds, many of which could not break out of the single digits, and the all-equity average still comes to 15.35%, according to Morningstar Inc. (Returns are through Dec. 13, 1996.)

Just as in the past two years, the average U.S. diversified fund trailed the Standard & Poor's 500-stock index, which earned a hefty 20.73% return. Most of the largest equity funds fell short as well (table). The main reason was that funds hold more small- and mid-cap stocks than are in the S&P, and those sorts of stocks lagged the big caps. But that underperformance is probably not going to sour anybody on fund investing. ''If a fund underperforms the S&P 500 by a few percentage points and still earns 15% or 16%, I don't think many investors are going to complain,'' says Ken Gregory, publisher of the No-Load Fund Analyst.

Who could complain, especially in the absence of compelling alternatives? Money-market funds yield less than 5%, and interest rates are not high enough to draw big money away from equities. There's another reason equity-fund investors will hang on even if the recent correction, which has already brought the S&P nearly 5% from its high, intensifies: They have long investment horizons. Avi Nachmany of Strategic Insight, a fund-industry consulting firm, says about three-quarters of the money in equity funds is in 401(k)s, individual retirement accounts and other forms of long-term savings. He also estimates that three-quarters of the new cash flowing to equity funds--which is already $208 billion in 1996--is also earmarked for long-term goals. ''These investors are not short-term opportunists,'' says Nachmany.

But if investors are making a long-term commitment to mutual funds, it doesn't mean they'll stick with the same fund or funds for all that time. Indeed, this is the time of year when investors typically review their holdings, and may even sell some winners--and for tax purposes, losers too--and go hunting for fresh opportunities.

NEW NAMES. With the fund industry stamping out hundreds of new funds every year, there's always something new to consider. One of the brighter new names is the $20 million Needham Growth Fund, up 52.4% this year. Run by Howard S. Schachter, a managing director at the institutional brokerage firm of Needham & Co., the fund focuses on companies with earnings growth of at least 20% a year. While scores of funds pursue that high-growth strategy, this fund is a little different. Schachter hedges the portfolio with options. So when the market went down 7% in June and July, the fund was off about 3%. Thus, unlike many growth-oriented managers, Schachter carried much of the first half's gain into the second.

Longtime fund watcher A. Michael Lipper of Lipper Analytical Services Inc. advises starting with this year's underperformers when looking for next year's outperformers. That means he would favor international funds instead of domestic, choose small-capitalization funds over large, and look for funds stressing ''value'' stocks--stocks with low price-earnings ratios or in unloved industries--over growth.

In effect, he's tilting investments toward the sorts of funds that have been laggards for the last three years. ''There's no law that a reversal has to happen,'' says Lipper. ''But the longer it takes reversals to happen, the greater the chance they'll happen.'' Real estate funds, up an average 26.69% this year, are an example of a reversal play since they underperformed most sorts of funds for the past two years.

International equity funds, a broad group that has long lagged domestic funds, looks like it may be staging a comeback. As a whole, it has earned nearly 11% so far this year. European funds, for instance, posted solid 18.42% returns, even in the face of a strong dollar. Emerging-markets funds came back to the black, too, up 8.65%, after several years of negative returns. Japanese funds remain a black hole for U.S. investors, with a stronger dollar undermining what little appreciation there is in Japanese equities.

Among the domestic funds, many investment strategists and mutual-fund managers point to 1997 as the year when small-cap stocks will once again outperform the big caps--something that has not happened since 1993. ''Small-cap companies have faster earnings growth and better balance sheets,'' says Mary Lisanti, portfolio manager of Strong Small Cap Fund. ''Relative to large caps, small caps have not been this cheap since 1990.''

That's not a guarantee of investment success. In the first five months of 1996, small-cap stocks and the funds that invest in them raced to a 19.6% gain, which at the time bested the S&P 500 by 10 percentage points. But then the summer correction hit. At the time, many thought it was the beginning of a bear market, and the high-flying small caps were hit even harder as investors fled for the more liquid S&P stocks. The market recovered and went on to record highs in the second half, but small-caps were left behind, and the average small-company fund today is about a percentage point lower than in the spring.

''VALUE'' FUNDS. Among the small-cap mutual funds, there are signs of another reversal, the switch from growth to value funds. Many high-octane growth funds that shone brightly and rode the crest of the initial public offering boom earlier in the year have fallen tremendously. Look at the Van Wagoner funds--Emerging Growth, Micro-Cap, and Mid-Cap--which opened for business in January and were up 56.6%, 42.1%, and 41.1% respectively by the end of May. Those funds are still in the black for the year, but their returns are only about half of what they were at the peak.

Fund investors who came in near the springtime highs are sitting with losses--if they already haven't cashed out. Manager Garrett R. Van Wagoner says patient investors will be rewarded in the new year. ''We own companies that executed their businesses strategies perfectly, yet the stocks have gone nowhere,'' says Van Wagoner. ''The market's going to wake up to that.''

As the growth-oriented small caps ebb, value funds are in ascendancy. Look at Warburg Pincus Small Company Value Common Shares, up 51.04%. George Wyper, one of the fund's managers, says he buys the sorts of stocks that go-go growth managers wouldn't touch. ''We like to buy a turnaround, a troubled company whose management comes up with a credible comeback plan,'' he explains. ''If we do it right, the stock has 5% to 15% downside risk, and a whole lot of upside potential.''

REBOUND. Perhaps one of the best examples of a snapback are the bond funds that invest in the debt of such emerging-market nations as Mexico, the Philippines, and even Russia. These funds, sold as high-yield plays, plunged in late 1994 and early 1995 when the Mexican peso crisis nearly destroyed the nascent market.

But the bonds came roaring back in 1996, as the economies of the debtor nations improved, enabling them to better service their debt. Despite the 1996 runup, Peter Lannigan, portfolio manager of Phoenix Emerging Markets Bond Fund A, up 50.56%, says there's still money to be made: The bonds yield nearly six percentage points more than Treasuries, and there's opportunity for capital gains as shaky debtors morph into investment-grade borrowers.

Don't mistake the best bond funds (table) for anything like the average bond fund. In 1996's ricocheting bond market, the average taxable fund earned a 5.73% total return, tax-free funds, just 2.86%, which next to equity funds, seem awfully dull. Is it any wonder why nearly all the new mutual-fund money is heading toward stocks?

By Jeffrey M. Laderman in New York



RELATED ITEMS

TABLE: The Best Returns

TABLE: The Worst Returns

TABLE: How the Big Funds Fared

TABLE: The Bond Fund Leaders

TABLE: Double-Digit Gains for Most Fund Groups

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Updated June 13, 1997 by bwwebmaster
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