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DECEMBER 29, 2003
Although The Top Sectors May Shift, Funds Have A Lot More Growing To Do It was a bittersweet year for mutual funds. A wide-reaching trading scandal tainted the industry, ensnaring some of the nation's most venerable fund families. But happily, that didn't dampen performance. The average U.S. diversified equity fund earned a total return of 29.7%, vs. 24.1% for the Standard & Poor's 500-stock index through Dec. 12. Inflows have remained strong, too, with funds raking in more than $63 billion since the scandal broke in September. Christopher N. Brown, a financial adviser at CommonWealth Advisory Group in Gaithersburg, Md., says none of his clients is complaining to him that "the fund industry stinks. You get fewer calls when things are going up." Fund managers are quick to point out it will be tough to match 2003's stellar returns. "It's going to be a positive market, but none of us is going to send in our application forms to Mensa," says John G. Goode, manager of the $4.3 billion Smith Barney Fundamental Value Fund. Even so, Bill Miller, manager of the $13 billion Legg Mason Value Trust Fund, which is likely to beat the S&P 500 for the 13th year in a row, with a return of 35.4%, remains bullish. "As we look out over the next 12 months, it looks like smooth sailing for equities," he says. Some of his favorite picks can be found in the fast-growing Internet arena, but he also likes advertising agency WPP Group and photo and imaging giant Kodak. Technology stocks lifted many funds in 2003, including Oberweis Micro-Cap Fund (OBMCX ), a small-cap growth fund that focuses on companies with market capitalizations below $250 million. The fund posted an eye-popping gain of 105.1%, making it one of the year's best performers (table). More than one-third of the $53 million micro-cap portfolio, which is closed to new investors, is stashed in technology stocks, which benefited from an uptick in corporate tech spending. (Funds that specialize in technology also soared in 2003, gaining 54.4%.) Will tech's momentum continue? With the economy in much better shape than it was a year ago, James W. Oberweis thinks so. He's especially high on the chipmakers. "The semiconductor cycle is coming into play -- especially from companies related to MP3, DVDs, and cell-phone technologies," says Oberweis, who also oversees Oberweis Emerging Growth Fund (OBEGX ), up 67.6%. He likes Omni-Vision Technologies Inc. (OVTI ), a maker of chips for digital cameras. While networking and hardware names performed well in 2003, software stocks lagged. That's why they've caught the eye of bargain shoppers such as Peter I. Higgins, portfolio manager of the $220 million Dreyfus Small Company Value Fund (DSGAX ), also one of the year's best performers, up 78.6%. Thanks to relatively cheap valuations and good earnings prospects, Higgins says software is one of the cheapest areas in tech. Ever the bargain shopper, Higgins is also eyeing energy stocks, which underperformed the broader market in 2003. He thinks they're poised to rebound amid increased demand for natural gas. Growth managers like Oberweis and value managers like Higgins traditionally don't shine in the same years. What made 2003 unique is that it was a year when both styles prospered. Large-company value funds gained 24%, and large-company growth funds rose 24.5%. And while small-company value funds increased 39.9%, small-company growth funds delivered the best results among diversified stock funds, up 42.1%. Reemerging markets Few experts expect small-company stocks to rise at a similar pace in 2004. "The small-cap outperformance probably is in the seventh inning," says Jack Laporte, a veteran small-company stockpicker and manager of the $4.8 billion T. Rowe Price New Horizons Fund, up 46.3%. "Small caps may continue to outperform over the next 6 to 12 months, but not at the same magnitude as they did in the past year." That's why managers are turning their attention to mid-caps -- typically companies with market capitalizations of $2 billion to $10 billion. "The next best thing to small caps will be mid-caps in 2004," says James R. Margard, chief investment officer at Rainier Investment Management, which offers several mutual funds. One area he's watching is advertising. Companies such as ValueClick Inc. (VCLK ), an e-marketing concern, should take off as advertising rebounds, buoyed by the 2004 Olympics and the Presidential election, Margard says. That said, investors shouldn't overlook large-company stocks. Blue-chip names should benefit from a falling dollar, which makes their sizable foreign profits more valuable. In addition, large companies have shed jobs while increasing productivity. Academic studies show that large caps tend to perform well in the second year of a recovery. There's even more money to be made overseas. Latin American funds gained 53.3%, while Asia Pacific funds (excluding Japan) rose 48.3% in 2003. Looking ahead, "the pronounced growth will be outside the U.S.," says Fred Taylor, chief investment officer at U.S. Trust (SCH ). Experts say some of the best bargains are in emerging markets. "Many stocks are undervalued there relative to the developed world," says Rudolph-Riad Younes, co-manager of the Julius Baer International Equity Fund, which gained 29.5%. More than 20% of the fund is invested in markets such as the Czech Republic, Poland, Hungary, and Turkey. Perhaps the biggest global growth potential is in Asia -- namely China and India, where education levels are high and consumption is growing. "You've got higher growth everywhere in Asia than you do almost anywhere else in the world," says David Linehan, manager of the $76 million Excelsior Pacific Asia Fund (USPAX ), up 34.6%. As a result, he's focusing on select retailers, auto makers, and other Asian companies poised to benefit as consumers open their wallets. The three-year winning streak for bond funds seems to have petered out. Traditional categories such as intermediate and long-term government funds delivered tepid results. There were some bright spots, though, including high-yield (up 21.4%) and convertibles (up 23%), both of which are closely tied to the equity markets. The good news is that the party for both sectors isn't over yet, although returns might not be as robust. Convertible bonds should continue to climb as the economy rebounds and companies look for financing. "If you have a combination of higher stock prices and higher interest rates, convertibles are really the cheapest access of capital for corporations,"says Nick P. Calamos, co-manager of several Calamos funds. "They are cheaper than debt, cheaper than equities." Corporate bonds are also one of the better bets because U.S. companies have healthy balance sheets, and credit risk is minimal, says Kevin Grant, who manages several bond funds at Fidelity Investments. Grant is not especially worried about rising rates because today's bond prices already reflect a somewhat higher interest-rate environment. Overall, investors shouldn't expect bond funds to regain their momentum anytime soon, especially as interest rates rise. "There are fewer opportunities, and yields are generally lower," says Kenneth J. Taubes, director of fixed income at Pioneer Investment Management Inc. But don't overlook the fixed-income market completely, especially for diversification. Even a small dose of carefully selected bond funds can go a long way in helping investors ride out any bumps in the equity markets.  By Lauren Young
BW MALL
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