Mutual funds: A ride reserved for the strong at heart

If you feel as though your investment portfolio is in a free fall and now is time to pull the rip cord, you've got plenty of company.

Not many mutual-fund investors were able to remain aloft during the first quarter's stock-market plunge. But analysts warn those still invested in the market to consider riding it out.

Returns from diversified US stock funds fell by 10.1 percent, their biggest quarterly drop in nearly six years, according to fund-tracker Lipper Inc. Nor did international stock funds, whose popularity has mushroomed in recent years, provide a safer haven. World stock funds shrank by 9.6 percent. Those losses would have been even larger were it not for the weakening US dollar, which produces currency-translation gains in foreign investments.

Only two types of stock funds showed any buoyancy: short-bias funds and gold funds. Short-bias funds use hedging strategies that profit from declining markets. The strength of gold funds reflected investor concerns over a flare-up in inflation and the dollar's erosion. All told, less than 4 percent of some 12,700 stock funds tracked by Lipper posted positive returns in the first three months of this year.

Beginning in early January, stock funds tumbled across the board, driven by severe stresses in the US credit markets. A laundry list of woes engulfed the economy, including major mortgage debt write-downs by leading banks and record oil prices. From its peak last October, the S&P 500 fell more than 15 percent before stabilizing toward the end of the quarter.

"The market's certainly gone well beyond a normal correction. We're probably in a bear market, although I doubt it will be a prolonged one," says James Swanson, chief investment strategist with MFS Investment Management in Boston. "If the US has entered a mild recession, as I suspect, stocks should be signaling an economic recovery before year-end."

"It's a bit late in the game to get aggressively defensive," adds Les Satlow, portfolio manager with Cabot Money Management in Salem, Mass.

Despite the torrent of bad economic news, the winds are shifting in a more favorable direction, some analysts say. To fend off recession, the Federal Reserve cut the federal funds rate by two full percentage points, its most aggressive easing in two decades. The central bank averted a serious financial crisis by arranging the takeover of Bear Stearns, a troubled investment bank. It also opened up its "lender of last resort" spigot to major investment banks for the first time in history. The Fed's swift actions, which gave stocks a big boost in recent weeks, "have been hugely important in rebuilding investor confidence," says Mr. Satlow.

Recent fund-flow data underscore a high level of aversion to risk by investors. "We've seen heavy flows into money-market funds lately and steady withdrawals from domestic-equity funds," says Tom Roseen, senior analyst at Lipper.

In contrast, mixed-asset funds, a popular option among those with 401(k) corporate savings plans, continue to enjoy large inflows. These funds, which typically allot one-third or more of their portfolios to bonds and other fixed-income securities, fell only 6 percent for the quarter.

So what's next?

Many market strategists expect more turbulence in the weeks ahead. Yet those who remain bearish for too long run the risk of missing a recovery, says Eric Bjorgen, senior analyst at Leuthold Group in Minneapolis.

1 | 2

Next