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MAY MUTUAL FUND PERFORMANCE

A Real Bear of a Month

Keep your fingers crossed. Maybe, just maybe, the worst of the stock market's correction -- or for many investors, the bear market -- has passed. Just days ago, the stock market rallied mightily on the news that unemployment rose 0.2% in May. Yes, in Wall Street's own perverse way, other people losing their jobs is good news. The reason: Higher unemployment means that the Federal Reserve's efforts to slow the economy are finally starting to work. In turn, that means the Fed's policy of hiking short-term interest rates might soon end.

No doubt that would calm the markets, which have been roiled by unprecedented volatility. The Nasdaq, which gets cited in the mainstream media now as often as the Dow, slid as much as 18% during May, brushing against 3000 intraday and closing at a low of 3164.6 on May 23. Even though the tech-heavy Nasdaq rallied back to 3400, or 7.5%, by the end of the month, the return for May was -11.9%. For the month, the domestic equity funds lost 3.35% vs. -2.08% for the S&P 500 and just -1.77% for the Dow.

Some of the best-performing mutual funds for May were "bear" funds, so called because they go up when the market goes down. The bear funds that did the best were those linked to the Nasdaq: ProFunds UltraShort OTC, up 16.6%, Rydex Arktos, up 9.6%, and Potomac OTC Short, up 9.2%. They are great trading vehicles but deadly holdings in a bull market. Even with the recent successes, the last 12 months' return on ProFunds UltraShort OTC is -72.7%. Yes, if you had invested $10,000 a year ago, you would have only $2,730 left.

GOOD VALUE. If anything, calling the market turns is an impossible game. A well-diversified portfolio of funds is a saner approach for most people. And the experience of the last few months points that out all too well. Just look at the value funds, which invest mainly in financial, energy, and gritty, industrial, Old Economy companies. These funds, which have suffered an exodus of investors over the last few years, are now strutting their stuff. They have outpaced the growth funds, most of which have gorged themselves on New Economy technology stocks. In May, large-cap value funds gained 0.72% compared to large-cap growth's -5.81%, while mid-cap value funds were up 0.34% compared to mid-cap growth's -7.55%. On average, small-cap value funds lost 1.47% during May, but that still was a good deal better than small-cap growth's -8.19% loss.

The value of value funds has been even more pronounced over the last three months. March through May, large-cap value gained 9.84% compared to large-cap growth's -7.23%; mid-cap value's 10.32% trounced mid-cap growth's -7.69%; and small-cap value, though up only 1.8%, looks a whole lot better than small-cap growth's -21.98%. Some of the stand-out value performers for the last three months include Stratton Growth (up 23%) and Kemper-Dreman High Return Equity A (up 22.1%) among the large-caps; S.G. Cowen Income & Growth (up 29.2%) and Dreyfus Mid-Cap Value (up 25.6%) among the mid-caps; and FMC Strategic Value (up 18%) and Prudential Small Company A (up 16.9%).

The shift to value is also seen in the sector funds. Natural-resource funds -- which buy mainly energy stocks -- were the best-performing of all funds over the last three months, up nearly 20%. Yet they have been sluggish performers for the past three years, with an average annual return of a paltry 4.16%. Or consider the real-estate funds, which invest mostly in real-estate investment trusts. They're up 10.48% for the last three months, yet the last three years have been a yawn, with an average annual return of just 1.28%.

None of this means that you should dump your growth funds in favor of value. Doing so would be just another form of market timing. But it does suggest that if you have five growth funds, you don't have a well-diversified portfolio. If you're shopping for value funds, take a look at Business Week's A-rated funds. Of the 123 funds with an overall rating of A for superior performance, only five are large-cap value funds: Fundamental Investors, Gabelli Westwood Equity, Investment Company of America, Legg Mason Value Trust, and Selected American Shares. These five merit attention because they earned that rating in a period that was still dominated by large-cap growth. (Even with the latest drubbing, 19 large-cap growth funds maintain their A ratings.)

Four mid-cap value funds also earned A ratings: Parnassus Equity Income, Strong Opportunity, Weitz Partners Value, and Weitz Value funds. There are no small-cap value funds that have overall ratings of A, but three have B+ ratings: Longleaf Partners Small-Cap, Royce Total Return, and State St. Research Aurora A.

TECH TRIPLES. Even if value funds are sitting pretty of late, the growth funds in general and the technology funds in particular are still worth owning. Heck, technology funds declined 27.84% in the last three months, but they're still up 81.43% over the last 12 months. And $10,000 invested three years ago in the average technology fund would have more than tripled. Likewise, an investment in any category of growth fund would still have beat the comparable value fund over both the last three-year and five-year periods.

Investing abroad often pays off when investing domestically doesn't, but that hasn't been the case of late. International equity funds were down 4.08% in May while domestic funds lost 3.35%. Year-to-date, international funds are down 8.46% while domestic are only down 1.31%. What's hurting the overseas funds is that the dollar is strong vs. most foreign currencies, which devalues non-U.S. equity prices for U.S. investors.

This has especially been the case in Europe, where the euro has been far weaker than most investors had expected. Japanese funds continue to struggle this year -- they were down 8.46% in May and 19.02% year-to-date as the much-anticipated rebound in the Japanese economy still remains much anticipated. Emerging-markets funds declined 5.22% in May and 13.18% for the year, victims of both turmoil in the developed market and rising U.S. interest rates. Higher rates are never good for the most voracious borrowers like Third World nations. Emerging-markets bonds funds lost 3.28% as well.

Nor are rising rates good for investors in most bond funds. All told, taxable bond funds lost 0.45% in May, bringing the return for the first five months of the year to -1.54%. The month's best showing came from ultrashort funds, which are up 0.37%, and short-term funds, up 0.21%. High-yield bond funds and convertible bond funds, which also move in sympathy with equity markets, struggled in May, down 1.65% and 3.95% respectively. Not surprisingly, many of the bond funds upgraded to the A-list this month are short or ultrashort in nature. Returns for nontaxable bond funds are also pretty predictable. They were all down in May, with an average loss of 0.61%. Short-term (down 0.07%) did better than both nationally diversified intermediate (down 0.49%) and long-term funds (down 0.77%).

The one surprise in a year of rising interest rates is the performance of the long-term government funds. They're up 4.51% year-to-date. They should be the hardest hit, but the U.S. government has been spending a good chunk of its budget surplus buying up the bonds. That set off a long-term bond-buying panic by insurance companies, pension funds, and perhaps even individual investors who need long-term assets to match their long-term liabilities.

If the economy is slowing for real and the Fed is nearly finished with rate hikes, look for the intermediate-term bond funds to catch up with the long-term funds. At this point, those funds are probably the better buy.

See you next month.

By Jeff Laderman in New York

Changes to the A-List
Equity funds rated against all other equity funds

Upgrades
Bridgeway Aggressive Growth
Buffalo USA Global Growth
Dreyfus Appreciation
Dreyfus Premier Balanced A
Eaton Vance Utilities A
Fidelity Dividend Growth
Fidelity Select Health Care
Gabelli Asset
Growth Fund Of America
IAA Trust Asset Allocation
Investment Co. Of America
Mairs & Power Balanced
Merrill Lynch Healthcare B
MFS Utilities B
Morgan Stanley Dean Witter Global Utilities B
Nations Asset Allocation Investor A
Parnassus Equity Income
Pioneer Fund A
SEI Institutional Managed Balanced A
SEI Institutional Managed Capital Appreciation A
T. Rowe Price Capital Appreciation
T. Rowe Price Personal Strategy Income
Turner Growth Equity
UAM Analytic Defensive Equity
United Accumulative A
United Income A
United Retirement Shares A
Van Kampen Utility B
White Oak Growth Stock

Downgrades
AIM Global Utilities A
American Century International Discovery Inv.
Berger Growth & Income
Citizens Global Equity
Citizens Index
Eastcliff Total Return
Fidelity Growth Company
Fidelity Select Electronics
Fidelity Utilities
Franklin California Growth A
Galaxy Equity Growth A
Guardian Asset Allocation A
Invesco Technology II
IPS Millennium
MFS Largecap Growth A
Oppenheimer Growth A
Quantitative Growth & Income Ordinary Shares
Reynolds Blue Chip Growth
Stein Roe Growth Stock Fund
SunAmerica Growth And Income B
T. Rowe Price Growth Stock
Vanguard U.S. Growth
WM Growth

Bond Funds
Taxable funds rated against other taxable funds, and tax-free municipal bond funds rate against other tax-free funds

Upgrades
American High-Income Municipal
Bernstein Short Duration Plus
Goldman Sachs Adjustable Rate Gov. A
Homestead Short-Term Bond
Hotchkis & Wiley Low Duration
Hotchkis & Wiley Short-Term
Montgomery Ca. Tax-Free Intermediate C
MSDW Short-Term Bond
PIMCO Low Duration Instl.
Scudder High-Yield Tax-Free
Scudder Limited-Term Tax-Free
T. Rowe Price Summit Intermediate

Downgrades
Alliance North American Govt. Income B
American High-Income
Countrywide Adj. Rate U.S. Govt. Secs.
Eaton Vance Strategic Income B
EV Classic Senior Floating-Rate
Evergreen Capital Preservation & Income A
Franklin Adjustable Rate Securities
Hough Florida Taxfree Short
Limited Term NY Municipal A
Merrill Lynch Adjustable Rate Secs.
Schwab Short/Intermediate Tax-Free Bond
T. Rowe Price Summit Municipal Income
Van Kampen Harbor
Vanguard Intermediate Tax-Exempt
WPG Intermediate Municipal Bond

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BW Senior Writer Jeffrey Laderman

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