Small markets. Big profits.

If you had invested in mutual funds three years ago, during the postdotcom gloom, which sector would have made you the most money? Real estate funds? No. Natural resources? Not quite.

The winning strategy was to pour your money into small and volatile developing economies. If you had been particularly prescient, you would have picked Latin American funds, which invested in nations like Mexico and Brazil. But a more geographically diversified approach - using what are known as emerging-market funds - would have served well, too. In the three years ending in June, emerging markets posted whopping annualized gains of nearly 23 percent.

"If you don't have a stake in emerging markets, you'll miss out on many of the world's fastest growing economies," says Patricia Higase, coportfolio manager of the Matthews Asia Pacific Fund, one of the seven Asian funds Matthews offers. "China's per capita income has quadrupled in the past 20 years," spurring economic growth throughout the Pacific region.

That's not to say investors in more stable, conventional markets didn't see gains, too, in the second quarter. But in most cases, they were far more moderate.

Among the positive economic indicators buoying the markets: robust first-quarter corporate profits, a benign inflation trend, and renewed strength in the US dollar against the euro. An unexpected dip in long-term interest rates also spurred hopes that consumers would keep spending for housing and other durable goods. Lower business borrowing costs also boded well for plant and equipment spending and continued job growth.

Although investors shed some of their anxiety over rising energy prices and fears of an economic slowdown, they didn't stick their necks out too far. As was true earlier in the year, fund investors gravitated toward value offerings that look for out-of-favor stocks, equity-income funds that own dividend-paying companies, and hybrid funds that mix bonds with stocks.

"There's still a large dose of caution in the money flows we track," says Andrew Clark, a senior analyst at Lipper Inc., a fund-tracking firm. Still, he adds, investors are gaining more confidence that the mature bull market remains intact.

In May, when the Standard & Poor's 500 index climbed almost 4 percent, about $18 billion was added to stock funds, roughly double April's intake, according to Lipper. More than half the inflow was earmarked for world equity funds, a sign of investors' penchant for diversifying their investments on a global basis. On the domestic side, income- oriented funds attracted heftier inflows than did growth funds.

But the good economic news and the influx of investor dollars didn't do much for the major stock indexes. The S&P 500 index rose about 1 percent in the quarter, while the Dow Jones Industrials, a narrower market gauge, fell 2.2 percent. That meant that midway through 2005, a typical S&P 500 index fund was still 1 percent below where it started, trumped by money-market funds and domestic bond funds, which rose by 2 to 3 percent.

Most categories of diversified domestic-stock funds finished the quarter in positive territory, but not by much. Among sector funds, the real estate group, aided by a drop in bond yields, was the top performer, rising 13 percent.

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