Small markets. Big profits.

With major stock markets stuck in the mud, some investors are digging up better results in far-away places.

If you had invested in mutual funds three years ago, during the postdotcom gloom, which sector would have made you the most money? Real estate funds? No. Natural resources? Not quite.

The winning strategy was to pour your money into small and volatile developing economies. If you had been particularly prescient, you would have picked Latin American funds, which invested in nations like Mexico and Brazil. But a more geographically diversified approach - using what are known as emerging-market funds - would have served well, too. In the three years ending in June, emerging markets posted whopping annualized gains of nearly 23 percent.

"If you don't have a stake in emerging markets, you'll miss out on many of the world's fastest growing economies," says Patricia Higase, coportfolio manager of the Matthews Asia Pacific Fund, one of the seven Asian funds Matthews offers. "China's per capita income has quadrupled in the past 20 years," spurring economic growth throughout the Pacific region.

That's not to say investors in more stable, conventional markets didn't see gains, too, in the second quarter. But in most cases, they were far more moderate.

Among the positive economic indicators buoying the markets: robust first-quarter corporate profits, a benign inflation trend, and renewed strength in the US dollar against the euro. An unexpected dip in long-term interest rates also spurred hopes that consumers would keep spending for housing and other durable goods. Lower business borrowing costs also boded well for plant and equipment spending and continued job growth.

Although investors shed some of their anxiety over rising energy prices and fears of an economic slowdown, they didn't stick their necks out too far. As was true earlier in the year, fund investors gravitated toward value offerings that look for out-of-favor stocks, equity-income funds that own dividend-paying companies, and hybrid funds that mix bonds with stocks.

"There's still a large dose of caution in the money flows we track," says Andrew Clark, a senior analyst at Lipper Inc., a fund-tracking firm. Still, he adds, investors are gaining more confidence that the mature bull market remains intact.

In May, when the Standard & Poor's 500 index climbed almost 4 percent, about $18 billion was added to stock funds, roughly double April's intake, according to Lipper. More than half the inflow was earmarked for world equity funds, a sign of investors' penchant for diversifying their investments on a global basis. On the domestic side, income- oriented funds attracted heftier inflows than did growth funds.

But the good economic news and the influx of investor dollars didn't do much for the major stock indexes. The S&P 500 index rose about 1 percent in the quarter, while the Dow Jones Industrials, a narrower market gauge, fell 2.2 percent. That meant that midway through 2005, a typical S&P 500 index fund was still 1 percent below where it started, trumped by money-market funds and domestic bond funds, which rose by 2 to 3 percent.

Most categories of diversified domestic-stock funds finished the quarter in positive territory, but not by much. Among sector funds, the real estate group, aided by a drop in bond yields, was the top performer, rising 13 percent.

Natural-resource funds, reignited by a surge in crude-oil prices, rose more than 3 percent. The energy sector, which has jumped 20 percent this year, is likely to see earnings growth slacken in the year ahead, says Standard & Poor's strategist Sam Stovall. Since a fair amount of good news is already reflected in oil- and gas-related stocks, investors should beware of chasing performance, he adds.

Large-cap stocks typically begin outpacing small-cap stocks in the later stages of a cyclical bull market. Yet evidence this is happening is still scant, says Mr. Clark. Instead, the bulk of new money flowing into domestic equity funds has gone to multi-cap funds, whose investment style is not restricted to either small or large companies. Many investors, Clark says, may lack the confidence to make specific style choices and are more comfortable going the multi-cap route.

Growth funds, by contrast, did perk up last quarter. Market laggards since the Internet bubble burst five years ago, large-cap growth funds averaged nearly 3 percent growth in the second quarter, beating the 1 percent average gain of large-cap value funds. Growth funds were buoyed by a resurgence in technology and healthcare, as well as a growing consensus among strategists that many traditional growth stocks are now reasonably priced.

Except for emerging-market funds, venturing abroad was not a winning strategy. World equity funds, a category with broad-based geographic exposure, rose less than 1 percent during the quarter. Though European stock markets outpaced markets in the United States, the dollar's rebound against the euro - up some 10 percent so far this year - hurt returns.

Still, emerging-market funds did advance more than 3 percent for the quarter. Latin American funds, in particular, were standouts, advancing more than 10 percent.

Definitions of emerging markets vary, but the term typically applies to developing countries with a per capita gross national product of $10,000 or less. Brazil, Korea, South Africa, Taiwan, and Mexico are among the largest markets. Many of the smaller markets don't have the liquidity, accounting transparency, or corporate-governance standards demanded by US fund managers.

About half of emerging-market fund assets are concentrated in Asia outside Japan and, to a smaller extent, Latin America. All told, emerging-market funds account for less than 10 percent of the $735 billion invested in world equity funds, according to Lipper.

Emerging markets in resource-rich countries such as Brazil, Australia, and Mexico are benefiting from strength in oil and commodity prices. Southeast Asia boasts rapidly rising consumer incomes and a burgeoning middle class.

Political and economic instability often take emerging-market investors on a wild ride, making large-cap international funds seem tame by comparison. That's why many experts recommend that emerging-market funds represent only a small part of a diversified equity portfolio.

"Since most large-cap equity funds own some foreign stocks, many investors with diversified equity portfolios already have 20 to 25 percent of their portfolio in international markets," says Vern Hayden, president of Hayden Financial Group in Westport, Conn. "If you can stand the volatility, a modest portion of that should be invested in one or two emerging-market funds." Among larger fund families with proven emerging-markets expertise, he cites Franklin-Templeton, Oppenheimer, T. Rowe Price, PIMCO, and American Funds.

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