Stock Funds: Rich Got Richer and Poor Got Poorer

Stock investing in the first quarter was all about surprises in much of the world: the sudden return of Japanese and emerging-markets stocks to the “hot” category, for example, while European stocks foundered.

But here at home, the biggest surprise for investors--especially mutual fund investors--was that virtually nothing changed: The rich stocks got richer and the poor got poorer.

And there’s little sense that momentum in the U.S. equity markets will shift any time soon.

In the first three months of the year, the bull market’s rich--large growth stocks and technology stocks--soared again, adding to last year’s spectacular gains.

With Monday’s big rally, the blue-chip Dow Jones industrial average, now back above 10,000 at 10,007.33, is up 9% year-to-date, padding its first-quarter gain of 6.6%.

America Online, perhaps the premier Internet stock, rocketed 90% in the quarter, and on Monday it tacked on more for good measure, surging $16.94 to a record $166.94.

Meanwhile, the U.S. market’s poor--”value” stocks and smaller stocks in general--remained mired in Wall Street’s underclass in the quarter.

The Russell 2,000 small-stock index fell another 5.4% during the quarter, bringing its 12-month loss to 16.2%. The average small “value” stock mutual fund slid 9.6% in the quarter and has lost 23% over the last year, according to fund-tracker Morningstar Inc.

“If there’s anything that surprised me, it’s the ongoing extremes that we’re seeing in the U.S. markets--the diametrical performance of value and small stocks versus the frothiest of frothy high-tech, big-cap and Internet stocks,” said James Stack, editor of InvesTech, a market newsletter in Whitefish, Mont.

For the second straight quarter, the two top-performing stock mutual fund categories were technology and telecommunications funds. Tech also is the No. 1 sector among all stock fund categories for the last five years.

The average tech fund, fueled by continuing interest in the Internet, gained 16.7% in the quarter.

The typical telecom fund, helped by continuing mergers in the cable TV and wireless businesses, advanced 15.9%.

Among U.S. stock fund categories, the next-best group was large-growth-stock funds, up 8% in the quarter and 28.1% over the last year.

Many of those growth funds own the mega-tech names that are the market’s superstars--Microsoft and Cisco Systems, for example.

Those names helped growth funds like Janus Twenty. The $20-billion fund gained another 23% for the quarter and is now up nearly 80% for the past year.

That’s in stark contrast to how large value funds, which by and large are restricted from investing in expensive tech stocks, performed. These funds, which invest in shares of big but beaten-down or overlooked stocks with low price-to-earnings ratios, gained just one-seventh what the typical growth stock did in the quarter. And over the last 12 months the average large value fund is up a meager 2.4%.

Yet no one has suffered like small-stock fund investors.

“It’s beyond frustration, way beyond it,” said Gerald Perritt, editor of the Mutual Letter in Largo, Fla., and manager of the Perritt Micro Cap Opportunity fund.

“I’m surprised that small caps didn’t fire this year,” said Perritt, especially given that the first quarter saw a resurgence of other higher-risk types of funds, such as emerging-market funds.

Other small-stock analysts now say they wouldn’t be surprised if small stocks don’t rebound for another six to nine months, if then.

“We’ve outlined a pretty much bearish case for small caps,” said Merrill Lynch small-cap analyst Satya Pradhuman in New York.

Why? In a volatile market, Pradhuman expects investors to continue to gravitate to the most liquid stocks--the big growth names.

Fund investors now are going with that flow: In January and February, fund investors were net sellers of aggressive growth funds, a proxy for small-cap portfolios. At the same time, they were net buyers of large growth stock funds, according to data from the Investment Company Institute, the fund industry’s chief trade group.

Rising interest rates aren’t helping small stocks, either: Higher rates increase the cost of capital for many small, growing companies.

Says Laura Tarbox, head of Tarbox Equity, an asset-management firm in Newport Beach: “We have a lot of reason to think large caps are going to outperform the rest of the year. At some point, the small caps are going to turn things around, because that’s where the values are. But the market just isn’t willing to recognize value in this environment.”

Which is ironic, because worldwide investors seemed quite interested in snapping up out-of-favor and otherwise distressed securities in the first quarter:

* After losing money in four of the last five years, the average Japanese stock fund available to U.S. investors soared 15% in the first quarter as money poured into Japanese shares, betting that the country’s long recession is ending. That was three times the gain of the U.S. blue-chip Standard & Poor’s index in the quarter.

While many investors weren’t looking, the average Japan fund now is up nearly 22% over the last 12 months.

Other Asian markets, however, slowed after a big fourth-quarter jump. Pacific-region stock funds that exclude Japanese stocks inched up just 1.6% in the first quarter.

* Latin American stock funds zoomed 11.3%, on average, in the quarter, despite initial concerns over Brazil’s currency devaluation. Mexico led the way.

* Diversified emerging markets stock funds, which may invest in all regions worldwide, gained 7.7% in the quarter, on average.

The disappointment overseas: European equity markets, which began the year with high hopes for the new single European currency. Instead, the euro fizzled, and the dollar’s strength against that currency chiseled away at the returns Americans brought home.

The average Europe fund lost 3.3% in the quarter and is down 2.2% for the last 12 months.

“The market is driven by surprises, either positive or negative ones,” says Larry Speidell, director of global research for Nicholas-Applegate in San Diego. “Lately, all the positive surprises have all been in Latin America, Asia and the U.S. for that matter--and not in Europe.”

“The Euro turned out to be a weak currency from the start,” Speidell said. “And that’s dragged down the overall equity returns, to say nothing about the impact of the disappointing progress in Kosovo,” referring to NATO’s airstrikes against Yugoslavia.

European economic growth also has been slower than expected. But that is leading to expectations that the European central bank will cut its already low interest rates further when it meets on Thursday.

Said InvesTech’s Stack: “If you look at the European markets, they were experiencing the same overvaluation as we see in the U.S. The only difference is, their economies have actually slowed down, and some of the air has been let out of their exuberance.”

Among U.S. specialty stock funds, the up-and-comer in the quarter was the natural-resources category, helped by the rebound in oil prices.

The average natural resources fund rose 6.5% in the quarter. But that sector still is off 22.7% over the last year.

Financial-services stock funds, stars of much of the 1990s, have slowed dramatically: Their average first-quarter gain was just 2.6%.

For several other specialty categories, the quarter was dismal. Rising market interest rates helped hammer real estate stocks and utilities. And gold’s long bear market continued, with the average precious-metals fund down 3.9% in the quarter.

With so much red ink washing across domestic stock funds, “Maybe the biggest surprise of the first quarter is that more money managers haven’t gotten shot this year,” said Perritt, “because none of us are beating the market.”

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Stock Funds: A Split Picture

For mutual fund investors, the first quarter was either about more gain or more pain: gain for investors in technology funds and large-growth-stock funds; pain for investors with significant sums in small-company-stock or real estate funds. Average gains or losses for key fund categories in the first quarter and over the last 12 months:

Winners:

Technology

Quarter: +16.7%

12 months: +51.7

Telecommunications

Quarter: +15.9%

12 months: +37.6

Large U.S. growth

Quarter: +8.0%

12 months: +28.1

*

Losers:

Small U.S. growth

Quarter: -1.9%

12 months: -7.5

Real estate:

Quarter: -4.9%

12 months: 21.0

*

Small U.S. value:

Quarter: -9.6%

12 months: -23.0

How Bad was It?

The percentage of all funds in each category that lost money in the first quarter:

Small value: 98%

Real estate: 97%

Precious metals: 90%

Small blend: 88%

Utilities: 77%

Europe: 75%

Small growth: 58%

Health care: 53%

Source: Morningstar Inc.

A Decade of (Mostly) Gains

The average U.S. stock fund edged up to 0.9% in the first quarter, as surging blue-chip funds were offset by declining small-stock funds. Since 1989 the average fund has lost money in only two calendar years. Average annual total returns and first-quarter gain:

First quarter; +0.9%

SOURCE: Morningstar Inc