Markets exceed modest expectations

"Gee, what a pleasant surprise!" That's what many stock fund investors are likely to exclaim when they pore over their midyear statements in the coming weeks.

Despite market jitters in June, when a sudden jump in long-term interest rates and leveraged hedge- fund woes made headlines, equity-oriented mutual funds turned in a strong showing in the second quarter. Although major stock market indices backed off from record highs set in May, little damage was done to most diversified stock portfolios.

It didn't matter whether investors held international funds or domestic offerings – both types enjoyed solid gains. See chart (PDF).

Among 18 types of diversified US stock funds tracked by Lipper, only one – dedicated short bias funds, which thrive in bear markets – lost ground. The laggards were funds with heavy stakes in real estate and financial stocks. Bank stocks, in particular, suffered from their sensitivity to rising interest rates and growing concerns about credit quality.

Funds that diversify their assets globally fared somewhat better than domestically oriented funds, but the differences were fairly slim. The average diversified US equity fund advanced 6.2 percent in the second quarter. World funds, a broad universe ranging from single-country funds to global funds with a stake in the US market, climbed 8.3 percent.

A narrow slice of this universe, funds specializing in Latin America, was a big winner last quarter, rising 20.2 percent. Other prominent gainers were funds that invest in China (up 21.5 percent) and the Pacific, excluding Japan (up 16.1 percent).

An overview of fund performance during the quarter suggests that large-cap stocks may soon emerge into the forefront again, analysts say.

Small companies, with their zippier earnings growth, have been market darlings for the past six years. But slower consumer spending, subpar US economic growth, and rising interest rates create stronger head winds for small companies than they do for larger ones.

Large-cap stocks typically outpace small-cap stocks in the later stages of a bull market cycle, says Lipper senior analyst Jeff Tornehoj, and that appears to be happening. "We're beginning to see signs of a trend reversal," he says.

Large-cap core funds advanced 6.4 percent in the quarter, closely matching the rise in the S&P 500 index (6.1 percent). Large-cap growth funds perked up as well, aided by renewed strength in information technology and healthcare stocks. For the quarter and year-to-date, mid-cap funds were the strongest performers, with the mid-cap core group returning 6.5 percent and 19.9 percent, respectively. Small-cap value funds trailed the pack, rising 4.8 percent.

"With risk averseness becoming more acute and corporate earnings growth fading, investors are more quality conscious," says William Hack­ney, managing director of Atlan­­ta Capital Management. High-­quality companies have sturdy balance sheets and a proven ability to boost earnings and dividends under varying economic conditions. For him, that makes a compelling case for buying multinational US companies, many of which are represented in the top capitalization tier of the S&P 500. "For the typical S&P 500 company, sales of foreign affiliates account for more than one-third of total revenues," he notes. "They will likely emerge as future market leaders."

Judging by money flows, investors aren't displaying much exuberance in their fund choices, according to Lipper data. Money market funds, many of which offer yields above 4.5 percent, received the lion's share of new money flows in May.

Can perky world markets last?

New purchases continue to favor mixed-equity and multicap funds over large-cap funds, which have seen sizable withdrawals since Jan­uary. World equity funds, on the other hand, are still a magnet for investors, garnering more than $11 billion in fresh money in May. "There has been little letup in investors' love affair with global markets," Tornehoj says.

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