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Hang On: More Surprises On The Way


Cover Story: WHERE TO INVEST: MUTUAL FUNDS

HANG ON: MORE SURPRISES ON THE WAY

The first half of 1995 has been full of surprises for mutual-fund investors. The Dow Jones industrial average rose faster and further than anyone anticipated, gaining nearly 17% as of June 6. The bond market stunned investors with a rip-roaring rally that sent the yield on the 30-year Treasury bond down to 6.5%, its lowest point in 15 months. Despite all of the record-breaking, the average equity fund return, at 10.2%, fell far short of the 17.3% total return of the Standard & Poor's 500-stock index. And in a quirk of financial fate, equity funds were outperformed by bond funds that focus on investments that were considered rather humdrum until recently--U.S. Treasury securities.

Much of the gain in equity mutual funds was generated by a narrow slice of stocks, mainly large-capitalization growth stocks and technology issues. Excitement in the volatile tech sector isn't unusual. But the sector still held surprises, as the cycle of demand in the semiconductor industry extended well past analysts' expectations. That persistent outperformance led to some of the year's biggest gains, such as the eye-popping 45.2% total return from the $750 million Fidelity Select Electronics Fund.

NEW FLOW. While individual tech funds produced the biggest total returns, funds that focus on financial stocks had the best average performance--a 20.3% total return. Financial institutions benefited from growth in lending, improved trading profits, and a boost in fee income and credit-card profits as a result of a higher prime rate.

Staying at home was another strategy that paid off for equity players. U.S. diversified equity funds returned 12.9% as of June 2, compared with 0.74% for funds that invest in foreign stocks. Steven Norwitz, spokesman for T. Rowe Price Investment Services Inc., says the biggest shift in fund flow at his firm thus far in 1995 has been out of international funds and into domestic funds. The worst returns showed up in funds targeting Latin America, Japan, India, and gold.

Bond funds did a dramatic about-face from 1994, when virtually every category of bond fund was in negative territory. But in 1995's first half, every category sported positive returns. Only two fund groups--short-term world income and government adjustable-rate mortgage--failed to generate a return of more than 8%. Government bond funds investing in Treasuries took the top slot, with an 11.5% average return, boosted by the powerful rally in the bond market. But many government bond fund managers, having built up more conservative positions in short and intermediate maturities in the wake of last year's market rout, didn't participate in much of the rally. World bond funds came in second, gaining 10.2%.

"RELATIVELY CHEAP." Indeed, it was focusing on the long term that provided some of the best returns. The $253 million Benham Target Maturities 2020, which buys long-term zero-coupon U.S. Treasuries, was the best-performing fund, up 33.6%. Going long also paid off for fund manager Daniel J. Fuss, who manages the $134 million Loomis Sayles Bond fund, as well as the $27 million Managers Bond fund, both strong performers. The Loomis Sayles fund sports an average maturity of 19.2 years and is call-protected.

Bond funds also profited by going overseas to look for profits. The $49.8 million SEI International Fixed-Income A Fund gained 20.5% for the first half, thanks to falling interest rates and a falling dollar. Much of the fund's holdings are AAA-rated foreign bonds that benefited greatly from the decline of the dollar against German, Japanese, and other currencies. Recently, the fund has started to shift out of the German market and into the bonds of more peripheral European markets such as Italy and Spain.

How did the megafunds fare? All but 3 of the 25 largest equity funds saw double-digit gains. The $11.7 billion Vanguard/Windsor fund led the pack with an 18.8% return. Tech-heavy, $41.8 billion Fidelity Magellan came in second, returning 18.2%. But only 4 of the 25 largest funds managed to beat the S&P 500's return.

The first-half performance numbers have many tech investors wondering whether they should run for the exits. In the near term, many fund managers expect a bumpy ride. Paul H. Wick, who runs the second-best performing tech fund, Seligman Communications & Information A, has turned neutral on tech for the short term but is bullish for the second half. (Investors who want to jump into his fund will soon be out of luck: It will be closed to new investors as of July 15.) Barry Gordon, who runs the $85 million John Hancock Global Technology Fund, is another tech bull. "I still feel that technology stocks are relatively cheap," he says. "More products are using more semiconductor chips than ever before." Some of his favorite stocks: Integrated Devices, LSI Logic, and Applied Materials.

Some fund managers are playing it safe, though. Michael W. Powers, who runs the $356 million Columbia Balanced Fund, is underweighting the technology sector compared with the technology weighting of the S&P index. Along with other fund managers, he is moving into energy service and oil stocks. Powers sees the out-of-favor S&P Oil Group as "an unexploited area that won't get bailed out by rising prices but is focusing on cost-efficiency and getting rid of businesses that aren't doing well." Baker Hughes is his fund's largest holding; if he could only hold one oil stock for a long time, however, he'd pick Royal Dutch/Shell Group.

FOREIGN TEST. While technology stocks have some managers nervous, fund managers are still enthusiastic about financial stocks. Ronald C. Ognar, who runs the $330 Strong Growth Fund, has been buying up niche companies such as Green Tree Financial Corp., First USA, MGIC, and MBNA. "These companies are growing at 20%, and most of the public hasn't even heard of them," he says.

Equity fund managers with a stomach for risk are venturing overseas, even into Latin America, where they believe the worst is over. The $565 million Robertson Stephens Contrarian Fund plans a slow move into emerging markets. For the long term, fund manager Paul H. Stephens likes Latin America, parts of Southeast Asia, and parts of Africa. Currently, however, many of his holdings are in Canada. His fund's 23.1% return is largely explained by a holding in Diamond Fields Resources Inc., a Canadian mining company whose stock has climbed from about 4 to 713/4 since the company's discovery of major nickel, copper, and cobalt deposits last year. An investment in Diamond Fields also propelled the $8.6 million Excel Midas Gold Shares Fund to a total return of 30%, while many of its peers suffered double-digit losses.

Gold bugs may be depressed, but bond traders are feeling totally flummoxed. Every week, market sentiment seems to shift with the latest economic statistics. There was some "good" news lately for bond investors: Signs of a rapidly slowing economy mean that the possibility of recession cannot be ruled out. That raises the prospect of an interest-rate cut by the Federal Reserve sometime in the year's second half--a boon for many bond funds.

"STAYING POWER." While unwilling to write off a continuing bond rally, many fund managers are taking defensive positions. Loomis Sayles's Fuss says the second half of 1995 will be a "tougher time." He is gradually building positions that aren't so closely tied to gyrations in the U.S. bond market, without giving up potential gains from a further rally in the U.S. He will probably buy more Canadian paper and recently sold some long zero-coupon bonds in Managers Bond and invested the money in 3.5-year BBB-rated paper. But "it's too soon to say that this is it and leave," he says. "This rally has staying power."

Will the laws of gravity hit the financial markets in 1995's second half? Fund managers argue that increased productivity will support continued strong earnings gains in many sectors of the economy, even if growth slows further. And if that happens, an upside for bonds could be in the cards. But only one thing seems clear in today's topsy-turvy financial markets: Investors are likely to experience even more surprises in 1995's second half.By Suzanne Woolley in New York


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