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MUTUAL FUNDS: CAN ANYBODY OUT THERE BEAT THE S&P 500?Only 10% of funds did it this year. Maybe small-cap funds will in '99Until 1998, mutual-fund investors have had three years of both good news and bad news. The good news: Your funds' managers made you a double-digit return. The bad news: You could have earned even more with a Standard & Poor's 500-stock-index fund. With so many years of underperformance, surely portfolio managers would have learned a few tricks on how at least to equal returns on the S&P 500. Yeah, right. About 90% of U.S. diversified equity funds failed to beat the S&P 500 in 1998, about the same as in 1997. But in 1997, when the S&P logged 33.7%, fund managers still earned a plump 24.1% total (including reinvestment of dividends and capital gains). In 1998, the S&P's total return is 21.9% (through Dec. 11), but the average domestic equity fund could scrape together only 7%, according to Morningstar Inc., which supplies fund data to BUSINESS WEEK (table, page 156). That's the worst showing since 1994. BIG-STOCK BIAS. International funds, on average, broke about even, though funds investing in emerging markets lost 28.76% of their net asset values in 1998 atop 1997's 5.3% decline. Even with knockout returns in specialty funds like technology, up 34.2%, and communications, up 30.25%, the all-equity fund average weighed in at just 5.04%. That's less than investors could have earned in the average municipal bond fund, 5.45% (table, page 156), or even a money-market mutual fund. Investors aren't abandoning funds, but they're changing how they use them. For the first 10 months of the year, net inflows to equity and hybrid (equity and bond mixes) funds were $151.5 billion, about $56 billion, or 27% below the comparable period in 1997. But during the 10 months, net flows to bond funds amounted to $61.2 billion--and flows to money-market funds nearly tripled, hitting $210 billion. The severe midyear correction, the worst in eight years, must have shocked neophytes who had only known upward prices for equity funds. But even seasoned sorts realized the virtue of diversifying away from equities. Still, how could such highly educated and well-paid managers have performed so poorly? In some cases, it's not entirely their fault. As has been the case for the past several years, large-company stocks gave smaller and midsize company stocks a good drubbing. That makes it especially difficult for the many funds that, by charter, must fish in waters other than the big-cap stocks. The managers of the very largest funds fared better than their smaller peers because they, by virtue of their size, are stuck with big stocks. So by going a little heavier on the stronger stocks and underplaying or ignoring the weaker ones, such funds can draw a bead on the S&P. Fidelity Magellan Fund bested the index by 1.6 percentage points (table). Why does the S&P perform so well? In rocky markets, many prefer larger companies with deeper pockets and greater resources. Fund buyers themselves also feed the big-stock bias by investing in index funds when they see them doing so well. Robert Adler, whose AMG Data Services tracks flows to funds, says inflows to S&P 500 funds have been robust since the market began to recover in mid-October, while cash continues to leave small-company and international funds. Indeed, the performance gap between large-cap and small-cap funds has reached historically high levels. ''This year, there's a 30 percentage-point difference between the performance of the S&P 500 and the Russell 2000 [a broad small-cap index],'' says Theodore R. Aronson of Aronson & Partners, adviser for the Quaker Small-Cap Value Fund. ''You'd have to go back to 1970 to find a gap like that between large and small caps, and before that, it's 1930.'' To many investors, small-cap funds are screamingly cheap. John Rekenthaler, research director at Morningstar, says the strong performance of large-cap stocks, coupled with lagging returns from small-cap stocks, have distorted price-to-earnings and price-to-book value ratios as well. Rekenthaler says large-cap funds own stocks with an average p-e ratio of 31, vs. 17.3 for small-cap funds; for large-cap funds, the p-b ratio is nearly three times as great, 6.4 to 2.2. Four years ago, large-cap and small-cap funds had nearly identical p-e ratios and the p-b ratios for large-cap funds were just 70%, not nearly 200%, higher. PERFORMANCE BOOST. But this year, even having your money in a large-cap fund was not enough. Large-cap growth funds trounced the total returns of large-cap value funds 24.87% to 7.53%. The reason: The growth funds owned a big slug of technology stocks, which did extraordinarily well, as did their pharmaceuticals and retailing stocks. Value funds typically own financial, energy, and industrial stocks, and those sectors were bombed during 1998. By and large, the year's best results came from technology funds (table). Even the best performers--ProFunds UltraOTC Investors, up 141.27%, and Potomac OTC Plus, up 85.76%--are really de facto tech portfolios. Both funds track the NASDAQ 100 index, and 6 of the 7 largest stocks in that index are tech companies; the seventh, MCI WorldCom Inc., is tech-related. Those seven stocks make up about 52% of the weight of the index--No. 1 Microsoft Corp. alone accounts for 23.7%--leaving the other 48% to the next 93 companies. That index zoomed 69.1% this year. What drives these funds' index-beating performance is that their managers use futures and options to boost returns; Potomac is designed to deliver 1.25 times the index, and the ProFunds portfolio twice the index. Both companies also run mirror-image bearish funds, designed to profit when their underlying indexes fall. But other than leveraging the indexes, there weren't too many ways to beat the index of late. ''Select'' or ''focus'' funds proved one way. Rather than buy hundreds of stocks, these funds concentrate on as few as 20 and build larger stakes. Among these select winners are Berger Select, up 62.08%; Janus Twenty, up 54.99%; and Marsico Focus, up 38.9%. Janus-managed funds, both the focused and more diversified, enjoyed especially strong returns. ''Our roots as a company are in picking growth stocks, and it all came to the forefront this year,'' says Scott W. Schoelzel, Janus Twenty Fund manager. ''We did well with cable, telecom, technology, and biotechnology.'' He also manages IDEX Growth A, up 47.42%, and ASAF Janus Capital Growth B, up 43.92%--both large-cap funds. A few small-cap funds earned bragging rights. Schroder Micro Cap Investors, for instance, gained 54.7%. Its secret? Portfolio manager Ira L. Unschuld raised cash in June and bought put options on the Russell 2000 index. Not only did he skirt the decline, but the fund also cashed in on the options. He started to buy again in October. Every year, some funds have stunning reversals of fortune, and 1998 is no different. Lexington Troika Russia Fund was up 67.4% in 1997. Thanks to Russia's well-publicized plunge into an economic black hole, it's down 83.14% this year. American Heritage Fund, 1997's top performer with a 75% gain, fell 57.14% in 1998. On the other hand, Matthews Korea I, down 64.5% last year, now looks stellar with its 78.85% recovery. But an investor who bought that fund at the beginning of 1997 is still down 38% on his original investment. South Korea is looking up, but many emerging markets are still ailing, and so are the funds that invest in them. The market turmoil has humbled many veteran fund managers. Look at Montgomery Emerging Markets R, with a -38.98% return, vs. -28.76% for the average emerging-markets fund. ''We were out of Asia early in the year, and so we missed some of the bounceback,'' says co-manager Josephine S. Jimenez. ''And we thought Latin America would do better.'' The fund is shifting some money out of Brazil, which is heading for recession, and sending it to Asia, where Jimenez thinks countries such as China, the Philippines, and South Korea are on the mend. Perhaps one of the most bizarre turns is the resurrection of the Steadman Funds. Two of these perennial losers jumped to the best-performers list, following last year's death of fund manager Charles W. Steadman. ''Mr. Steadman was a pretty good stock-picker, but he traded too much and ran up high costs,'' says Max Katcher, Steadman's chief operating officer. Katcher says he has culled the portfolios, slowed trading, and renamed the group Ameritor. He'll try to market some funds next year, but Ameritor Security Trust, with expenses of 7.3%, will be a tough sell--even if it did earn over 50%. Most investors will take a pass on the former Steadman funds, but their reappearance among the winners might be an omen. If these funds can beat the index, there's still hope for the 90% of fund managers who haven't.
By Jeffrey M. Laderman in New York RELATED ITEMS
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Updated Dec. 17, 1998 by bwwebmaster
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