Amid gloom, a gusher

Natural resources and utilities sparkled in an otherwise down market.

The first three months of 2005 hit mutual-fund investors like a new well spouting oil. Either they rode the gusher to impressive quarterly returns - or they got covered by a black gooey rain.

In the first category were investors holding natural-resources or utilities funds. In the second category was just about everyone else as record-high oil prices and the Federal Reserve's repeated tugs on the monetary reins roiled the market. Even gold funds, traditionally viewed as a hedge against inflation, retreated.

There's a lesson in all this, analysts say. Natural-resource funds will zig-zag in the months ahead, but those who hold on for the ride can expect more gains.

Commodity prices will probably soften later this year after a three-year run-up, notes Nicocles Michas, investment strategist with Alexandros Partners LLC in Waltham, Mass. "However, profits and stock prices of energy and basic-material companies will probably continue to excel in both relative and absolute terms."

No one needed an investment adviser to figure that out last quarter. Buoyed by rising oil prices and strong demand for basic materials such as steel and copper, natural-resource funds rose an average 12.5 percent in the quarter, after gaining more than 35 percent annually in 2003 and 2004. Virtually all other major fund categories lost value. US diversified stock funds fell an average 2.5 percent in the quarter, the worst showing since the first three months of 2003. according to fund-tracker Lipper. United States growth funds, which favor stocks with superior earnings prospects, were especially weak. Large-cap growth funds declined about 4.6 percent on average, while small-cap growth funds slid 5.4 percent. Among US diversified equity funds, value styles outpaced growth, a trend that has persisted since the market peaked five years ago.

The dim fund performance reflects a maturing stock-market cycle with fewer and fewer stocks setting new highs, analysts say. Although US stocks overall reached a three-year high in early March, optimism faded rapidly after the Fed raised its benchmark short-term interest rate for the seventh time in a row. The Standard & Poor's 500 index shed 2.6 percent for the quarter.

As the market declined, investors turned defensive, says Don Cassidy, senior research analyst at Lipper who tracks fund flows. They pulled money out of growth funds, wary about volatile sectors such as technology and telecommunications. And they poured it into value funds, which gravitate toward dividend-paying stocks, as well as mixed-equity and real estate funds.

In addition, the decline in the value of the dollar and fears it would fall further persuaded investors to invest abroad. "World equity funds continue to attract attention, more so than domestic stock funds," Mr. Cassidy says.

In February, for example, some $12 billion, more than half of all the money earmarked for pure stock funds, went to world equity funds. This segment includes funds that invest solely overseas as well as global portfolios with a sizeable stake in the US market.

But the dollar rallied in the quarter, which helped push world equity funds down 0.1 percent.

With half of the world's $21 trillion stock market represented by non-US equities, it's no surprise that a growing body of investors are building multifund international portfolios. It makes just as much sense for investors to divide their international assets among a diverse set of offerings as it does for them to spread a domestic funds portfolio among different managers, says Morningstar analyst William Rocco. For the do-it-yourself investor seeking no-load fund families with solid international expertise, Mr. Rocco cites Artisan, Dodge & Cox, Oakmark, and Tweedy, Browne Co.

The best-performing international funds over the past three years have emphasized small- and mid-cap stocks. These funds exploited a wide valuation gap between large- and small-cap issues that existed in European and Asian markets five years ago, but has now largely disappeared, according to Tim Guinness, London-based manager of the Guinness Atkinson Global Innovators Fund. "What will matter most going forward," Mr. Atkinson says, "is not so much the size of a company's market capitalization, but choosing the right markets and sectors."

Mr. Guinness is particularly bullish on the long-term prospects for energy and natural-resource stocks. With Chinese, Korean, and Southeast Asian economies expected to serve as key engines of global growth in the years ahead, he believes that savvy investors can't afford to overlook emerging markets.

On the domestic front, real estate funds ran out of steam after a three-year climb as interest rates ratcheted upwards. Despite dividend payouts of 5 to 6 percent, real estate investment trusts (REITs) lost some of their luster as 10-year Treasury yields edged above 4.5 percent in March. The yield spread between 10-year Treasuries and REIT dividends has fallen well below the historical average of 1.25 percent, putting downward pressure on REIT shares, notes Jonathan Litt, an analyst for Smith Barney. "REIT shares may deliver flat to negative 10 percent total returns in 2005."

In a sharp break with recent history, small-company funds trailed their mid- and large-company brethren. "Although small-cap earnings remain strong, investors seem anxious after six consecutive years of small-cap outperformance," says Paul Kandel, portfolio manager of the Dreyfus Growth Opportunity Fund. Existing high valuations coupled with the likelihood of tougher earnings comparisons could dampen future stock gains, according to Mr. Kandel.

Facing headwinds of inflation fears, reduced financial liquidity, and a probable slowdown in corporate profits, few fund managers enter the second quarter with high hopes for a market upswing.

"There are a lot of yellow flags waving," says Chuck Zender, coportfolio manager of the Grizzly Short Fund, a no-load fund that caters to sophisticated investors employing the fund as a hedge or in "market neutral" strategies. The Grizzly Short Fund is one of three funds advised by Leuthold Weeden Capital Management in Minneapolis. The funds rely on a time-tested proprietary quantitative model that has more than 170 variables. "Based largely on the model," says Mr. Zender, "we've been increasingly cautious and have reduced our allocation to equities.

"Based on our research from 1900 to date, the market typically peaks about 27 months after hitting its low, which occurred in October 2002. If this is a typical bull market, this upswing is long in the tooth, and we haven't had a significant correction."

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