Mutual funds: A long climb to recovery?

Emotionally shaken and feeling a lot poorer. How else to describe the mood of many mutual-fund investors as the new year begins?

A wrenching bear market, the worst in more than 30 years, battered portfolios in 2008, with the vast majority of stock-oriented funds losing more than a third of their value. Only the most conservative bond funds holding large chunks of high-grade bonds, especially US Treasuries, were relatively unscathed.

Most of the selling onslaught came during a tumultuous fourth quarter, marked by hedge-fund deleveraging, a freeze-up of credit markets, and a deepening recession. After Lehman Brothers failed, financial markets hit the skids. The ad hoc nature of the Treasury's rescue measures for troubled banks also took a heavy toll on investor confidence. As the Federal Reserve slashed interest rates, parallel efforts to inject capital into the banking system did little to spur lending. Before stabilizing at year-end, the S&P 500 index had sunk more than 50 percent from its October 2007 high.

The full year and fourth quarter showed "the worst returns since we began tracking equity funds in 1959," says Tom Roseen, senior analyst at Lipper in Denver. The average diversified US stock fund dived 37.5 percent for the year, 23.2 percent for the quarter. Only one stock fund category tracked by Lipper advanced – short-bias funds, which are designed to profit when stocks plunge. Over the past 10 years, the average equity fund eked out an annual gain of less than 1 percent. "All told, you virtually erased 10 years of gains in a single year," Mr. Roseen says.

Some advice from market analysts: Don't bail out of the market now out of fear or frustration. A defensive stance is warranted, but hunkering down in money-market funds or government bonds is probably shortsighted. You'll likely miss the turnaround when it comes.

"Stocks outperform bonds over the long term, and stock valuations are deeply undervalued by most measures. They've more than discounted the worst recession in 30 years," says James Swanson, chief investment strategist at MFS Investment Management.

The recent relative stability in the market could be the forerunner of a bumpy but sustainable upturn in stock prices, he believes.

Diversification is one of the first rules of prudent investing. Last year, however, hedging your bets with funds that invest in a variety of stocks was of little help. "There is no way to stock-pick your way out of a raging bear market," says Les Satlow, portfolio manager with Cabot Money Management in Salem, Mass.

Bonds proved to be a more effective diversifier than real estate, precious metals, or foreign stocks, which plunged along with equities. For example, a portfolio 100 percent invested in stocks over the past five years would have had a negative annual return of 1.4 percent, according to fund-tracker Morningstar in Chicago. But if half of the portfolio held long-term government bonds, it would have returned almost 4 percent.

Looking ahead, optimism remains in short supply. Uncertainties abound regarding the effectiveness of US Treasury initiatives to mitigate the downturn by buying impaired assets and reviving the flow of credit. Corporate profits are eroding and fourth-quarter earnings reports, due out in the weeks ahead, are expected to make for dismal reading.

Still, some analysts contend that the risk/reward ratio is no longer heavily tilted against equities as it was a year ago. With the S&P 500 some 20 percent above its November low, the market's bottoming-out process is well under way, says James Stack, president of Investech Research, an investment advisory service. One significant indicator: Despite a stream of grim headlines, stocks' downward volatility has begun to ease and small-cap stocks have begun to strengthen relative to large-cap stocks.

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