Mutual Funds Quarterly: Time to set sail for growth?

Smiling, perhaps, but hardly jumping for joy. That depicts the mood of most mutual-fund investors as year-end performance statements begin to fill millions of US mailboxes. Fund portfolios liberally laced with stocks in foreign and small companies, or specialized sectors produced solid returns in 2005. Investors who owned funds packed with large blue-chip companies, on the other hand, experienced lackluster results.

Still, the vast majority of US equity funds beat the Standard & Poor's 500 index, which rose 3 percent for the year, well below its long-term trend. The average US diversified equity fund grew 6.7 percent in 2005, the third upside year in a row, according to fund-tracker Lipper Inc. Almost half of the gain came during a spirited market rally in November, when Wall Street shook off fears of soaring energy prices and a hurricane-induced economic slump.

"It was definitely a year for stock pickers rather than passive indexers," says Don Cassidy, Lipper Inc.'s director of fund analysis. Most of the more sprightly funds skirted the large companies that dominate the S&P 500 index, a favorite benchmark for passive investment strategies. While S&P index objective funds rose 4.4 percent for the year, large- and mid-cap growth funds posted gains of 6.2 percent and 9.8 percent, respectively. Many growth funds benefited from forays into non-US stocks and flexible charters that allowed portfolio managers to snap up stocks of midsize companies in sectors such as energy, healthcare, and technology.

International markets were a great place to be in 2005, especially in Latin America and Asia. Smaller Latin American funds rose 53 percent, while Pacific-region funds advanced more than 27 percent on average. International multi-cap growth funds, the most popular choice of investors venturing abroad for the first time, grew 15 percent, almost double the gain of their domestic counterparts.

Sector funds specializing in natural resources, real estate, and utilities cooled off during the fourth quarter, but retained their outsize gains for the year. Though easing oil prices sapped some strength from natural-resource funds, they soared 40 percent for the year. Utility funds, popular for their dividend yields, increased 14 percent for the year.

After trailing their small-cap rivals for six years, large-cap offerings were widely expected to edge out small- company stock funds in 2005. While that didn't happen, small-cap leadership appears to have faded, according to Leuthold Group, a Minneapolis-based investment advisory firm. "Small-cap stocks traditionally sell at a discount to large- cap stocks," says Leuthold senior analyst Andrew Engel, "But that's not the case anymore, and they look to be overvalued going forward."

If some investors pout over 2005's slim gains, the reason may lie in the disparity between the top-performing segments of the market and where investors' assets are actually lodged. Some 30 percent of stock-fund assets reside in large-cap stocks found in the S&P 500. That represents the core holdings of most small investors, says Mr. Cassidy. Less than 5 percent of these assets are where most of the sizzle has been, namely, natural resources, real estate, and international funds focused on smaller companies, the Pacific region, and other emerging markets.

Since the Internet bubble burst more than five years ago, value-oriented strategies, especially those focused on small- and mid-cap stocks, have led the performance derby. In 2005, however, returns on growth funds edged out value funds by a narrow margin. Value funds have enjoyed a prolonged wave of inflows, while monies for growth funds have dwindled. Many Wall Street strategists now believe that the tide is turning in favor of growth stocks and are advising investors to realign their portfolios toward large-cap stocks with superior earnings growth potential.

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