Index Funds Pass Baton To Stock Pickers

Fund Overview

Wall Street gave investors clear messages in the third quarter: "Out with the big stock, in with the small." "Out with the index fund, in with the actively-managed portfolio."

And by the looks of things, analysts say, investors would be wise to heed those words well into 1998. Actively managed, small-capitalization mutual funds may be the best place for investors to put their money during the next several months.

"This has truly been a stock-picker's quarter," says Gerald Perritt, who manages the Perritt Capital Growth Fund, based in Chicago. And "the smaller the company, the better it's been."

Mr. Perritt's small-cap fund is up some 40 percent this year.

The quarter marked an impressive turnaround for actively managed mutual funds. Average US-stock fund gains of 12 percent for the July-September quarter easily outpaced index funds (up 7 percent) that track the Standard & Poor's 500 index of large companies and require minimal management. The last time that happened on an annual basis was 1993.

High-tech stocks did even better: up 19 percent, according to Lipper Analytical Services in New York.

Even index-fund advocates admit the investing climate has changed.

"I'm a big believer in index funds," says David Blitzer, chief economist at Standard & Poor's in New York. But "the values are likely to be small-cap and mid-cap [stocks].... That's where I would look for the activity in the fourth quarter."

One big reason is that large-cap stocks - those that make up the Dow and S&P 500 - have had such a big run. They're so expensive that small-cap stocks look reasonable by comparison, despite their risk, Mr. Blitzer says.

Of course, several obstacles could trip everybody up, he adds. Although the economic picture in the United States remains bright, the market is 20 percent overvalued, Blitzer reckons. That means small stocks as well as big ones.

And investors could get spooked by a rise in interest rates (everyone's favorite tripwire) or a hike in inflation. The recent spike in oil prices because of Iran-Iraq tensions bears watching.

"Farther out, to sustain this advance, it would be nice to see the economies in Europe and Japan come back a little bit," Blitzer says.

Some analysts believe the market is on the verge of a downturn.

Michael Flament, an economist at Wright Investors' Service in Bridgeport, Conn., sees a 15 percent correction ahead.

Others suspect the correction may have already come and gone. This summer, the Dow Jones Industrial Average slipped about 7 percent to about 7600 from its record high above 8200. This week the Dow was back over 8000.

"We're encouraged by the broadening in the rally of the smaller-cap stocks," says Mr. Flament. "The question is ... can a rally there sustain the rest of the market?"

Strictly by the numbers, no.

The small-cap sector lacks the clout to buoy the market if big stocks founder. Taken together, all companies worth $300 million or less are outvalued by General Electric alone, portfolio manager Perritt points out.

An important element to small-cap investing, analysts say, is diversification. Perritt suggests conservative investors should have a 5 percent exposure to small-cap funds. Those feeling a bit more aggressive might put a third of their money there, a third in large-cap stocks, and the rest in international stocks.

But if you buy international funds, prepare for patience. European funds gained only 6.23 percent for the third quarter, although some analysts think European economies are set to match US performance. Funds investing in Pacific Rim companies, by contrast, lost more than 11 percent. The idea behind international diversification is that if the US market loses steam, foreign markets won't necessarily follow.

Back in the US, if small-cap stocks outperform the market in one year, they're historically likely to do so the next as well, Perritt says.

Mr. Flament echoes the diversification theme: "If you have a portfolio of Dow-type stocks, the kinds of stocks that have done so well over the past three years, then you might suffer bigger declines than that 15 percent. But if you have a reasonably diversified portfolio of high-quality neglected stocks - small-cap, mid-cap - then you'll be happy with how you do."

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