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Mutual Funds Were Worth Waiting For


Finance: FIRST QUARTER SCOREBOARD

MUTUAL FUNDS WERE WORTH WAITING FOR

Patience may be its own reward, but when it comes to investing, the payoff is profits. Investors who stuck with their mutual funds through the sometimes dark and stormy markets of 1994 are now finally getting their reward. Funds that invest in U.S. stocks are sizzling, with returns of 7.5% for the quarter (through Mar. 27), including reinvestment of dividends and capital gains. Even more striking are the bond funds, which were pummeled last year in the worst bond-market rout since the Great Depression. Taxable bond funds posted an average 4% total return. And tax-free bond funds, after being even harder hit in '94, averaged a remarkable 6.3% gain for the quarter.

This strong fund performance should come as no great surprise to investors who have kept an eye on the markets this year. The Dow Jones industrial average crossed the 4000 mark weeks ago and is now up 8.4%. The Standard & Poor's 500-stock index hit a record of its own--the 500 mark--and is up more than 10%, including dividends. Both the Dow and S&P outpaced the average U.S. diversified equity fund, primarily because funds tend to invest in smaller companies. The funds matched the S&P MidCap 400 index and ran far ahead of the S&P SmallCap 600 index. The all- equity fund average was up only 4.2%, mainly because of heavy losses among the overseas funds, especially those that invest in the emerging markets of Latin America and Asia.

The zooming U.S. stock market is taking its cues from the bond crowd, which has turned bullish, betting on the mounting evidence that the Federal Reserve's yearlong efforts will succeed in cooling the economy without killing it. So far this year, the interest rate on long-term Treasury bonds, at 7.4%, is down more than a half a percentage point and nearly a whole percentage point from its November, 1994, peak in rates. Some of the fund categories with the quarter's best performances are interest-sensitive--specialized financial, growth-and-income, balanced, and equity-income funds (table, page 124).

The recovery in fund performance has sparked a pickup in investment, too, but the industry is still a ways from the halcyon days of 1993. According to the Investment Company Institute, stock funds banked net new cash of $8.7 billion in February atop January's $6.8 billion. Back in November's depths, the inflow was a mere $3 billion. Bond funds counted $1.1 billion net new cash in February--the first time in a year that more money went in than came out.

TIMID STAY TIMID. But to see what's really happening, look at which funds are getting the cash. Robert Adler, whose AMG Data Services tracks weekly flows to funds, says so far this year about 75% of the net cash winds up in growth-oriented funds that usually buy smaller stocks, take greater risks, and have potentially higher payoffs. Funds that appeal to the risk-averse are still suffering outflows. The same pattern shows up among the bond funds. Most of the cash is flowing to municipal and junk corporate bond funds, which tend to attract more sophisticated investors. "The more conservative investors are still on the sidelines," says Neal Litvack, executive vice-president of Fidelity Investments. "They're waiting to see if this move can be sustained."

Of course, that's the $64 billion question. So far, the mutual funds have not been the driving force behind the stock market's dramatic surge. But if funds' inflows keep increasing, then the market could get an added boost. That would be welcome news for market laggards, especially the small-cap stocks that are not in the S&P 500.

One sort of investment that has yet to rebound--in its performance or ability to attract new money--are the funds that invest abroad. Foreign-stock funds, the category that includes many emerging-markets portfolios, are down 6.9%. They're still reeling from the peso crisis that started in December and reverberated through Latin America and Asia. The quarter's worst performers are the Latin funds. Their huge losses of 20% or more may look bad now, but a few weeks ago, they were worse. It's too soon to call it a turnaround, but many Latin funds are up 20% from their lows.

HELPLESS YEN. Nevertheless, two international funds, GAM Global and GAM International, are among the best funds of the quarter. But their hefty returns come not so much from shrewd stock-picking as from bulking up on German bonds, which soared in value as the U.S. dollar reached a new low against the mark. "We don't think stocks are going to fall out of bed," says John R. Horseman, who runs both GAM funds. "Bonds simply offer better value." Only about 10% his funds' assets are in stocks.

The dollar's plunge vis--a-vis the mark and yen helped to boost returns in international bond funds. Funds that go heavy on mark- and yen-denominated securities--and don't hedge them back into dollars--made the biggest gains (table, page 124). But strong currencies can't overcome sinking stock prices. The worst-performers' list is also peppered with Japanese funds, despite the soaring yen.

Investors did not have to stray far from home to score big bucks this year. Just look at Perkins Opportunity Fund, a tiny, $11 million fund in Wayzata, Minn., that is up 22.4% so far this year atop last year's 14.9%. The fund invests in small, emerging growth companies, and by policy prefers at least half the portfolio to be based in the Upper Midwest. "These can be risky investments," says Daniel S. Perkins, who runs the fund along with his father, Richard, at Perkins Capital Management Inc. "But these companies are nearby, we know them well, and we are comfortable buying them." Their major holdings may not even be household names in Minnesota: InnerDyne, Plaintree Systems, and CNS.

RIPE PICKINGS. Geography may have had some role in their success, but most of the Perkins' companies are in the health-care and computer-technology sectors, which are among the most robust areas of the market. And most funds that made it to the quarter's top-performers list were heavily into one or the other or both. "Those are areas where you see new products and innovations all the time," says Graham Y. Tanaka, who runs Retirement Planning Growth Fund, up 21.2% for the quarter. Among Tanaka's major holdings are Adaptec and ASM Lithography in technology and Pfizer and Teva Pharmaceutical in health care.

At BT Investment Small Cap Fund, another hot fund, portfolio manager Mary Lisanti has racked up 16.8% growth this year by concentrating more than two-thirds of the fund on health care and technology. In those sectors, she's buying stocks of companies that enhance productivity, such as Macromedia Inc., which sells software development tools, and Phamis Inc., which provides information systems for the health-care industry.

Of course, capturing hot stocks in a small fund can really enhance performance. The really big equity funds had mixed results (table, page 123). The $38.2 billion Fidelity Magellan Fund racked up a neat 9.4% gain. That was still behind the S&P, as were the returns of most of the diversified funds at Fidelity. The stock market's shift to large consumer growth stocks caught the Fidelity crowd quite off guard. "It was a Coke and Pepsi market," says George Vanderheiden, who heads Fidelity's group of growth funds, "and we were underweighted in those kinds of stocks."

CALIFORNIA CREAMING. Among the bond funds, the big story is the comeback in the muni market. Veteran muni-fund managers, like Alliance Capital Management's Susan Keenan and Smith Barney Inc.'s Joseph Deane, say they knew all along the snapback would come. Mutual-fund investors weren't so sure. Late last year, bond-fund redemptions hit their peak. And if that weren't enough pressure, the collapse of the Orange County investment pool and subsequent bankruptcy filing put even more selling pressure on munis, especially in the huge California municipal-bond market. "Munis got so cheap" relative to taxables, recalls Keenan, that already tax-exempt investors like pension funds bought them "for the tremendous opportunity." Keenan's Alliance funds loaded up as well--a bold move, considering some of her funds were down 10% for last year.

0 The rebound bet paid off handsomely. Since then, long-term AAA munis have shot up about 15% in price. Moreover, says Deane, munis have not yet run their course "and still offer excellent value." He estimates that over the next two years, $100 billion more in bonds will be retired than issued, making remaining bonds ever more valuable. And the demand for tax-exempt bonds will be there, says John Teall of Lipper Analytical Services Corp. "One thing you can count on is that Americans hate to pay taxes."

The lesson for mutual-fund investors from this quarter's rally is clear: You may feel better by bailing out when the market gets choppy, but you also risk missing the gains when the rebound takes hold. Patience, patience.By Jeffrey M. Laderman in New York


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