Mutual Funds: THIRD-QUARTER REVIEW FOR INVESTORS : THE GLORY DAYS HAVE PASSED. WHAT DO INVESTORS DO NOW?

Not quite 11 years old, the Wayne Hummer Growth stock mutual fund has never had a losing year. But with three months left to go in 1994, portfolio manager Tom Rowland knows his winning streak is in jeopardy.

The $94-million fund closed the third quarter off about 1% for the third quarter off about 1% for the year to date. Like many U.S. fund managers, Rowland has found it difficult to make much headway for his shareholders in a U.S. stock market beset by rising interest rates, inflation jitters and increasing competition from other types of investments.

Worse for Hummer investors, this is the second consecutive year of disappointing results. Last year, the Chicago-based fund eked out a mere 3.6% rise, barely above the rate of inflation and far below the double-digit returns that fund owners have come to expect since 1982.

Rowland is struggling through a market phase that Wall Street has long been anticipating--and fearing. After the wild bull market of the 1980s, wringing big gains out of U.S. stocks now is a tough order.

What ails the market is not so straightforward as to merely be labeled a bear cycle, experts say. Academics call it something else: “regression to the mean.”

Simply put, because investors enjoyed such huge returns on U.S. stocks from 1975-1989, it’s logical to assume that a lengthy period of overall weak performance--encompassing both bull and bear markets--may ensue in the ‘90s.

That would ensure that the average annual return on stocks over, say, the 1970-to-2000 period would be in line with the longer-term mean--which, theoretically, is the best return you can reasonably expect from the market over time.

“Regression to the mean is a statistical inevitability,” says Robert Markman, whose Markman Capital in Minneapolis directs $265 million in client assets in funds.

But that doesn’t make it easier for investors to swallow. Indeed, the possibility of sub-par returns for an extended period on U.S. stocks--perhaps 5% to 8% annually, compared to 17% a year during the 1980s--poses a monumental challenge for the $2-trillion mutual fund industry, which has attracted an unprecedented number of individual investors since 1990.

Though most fund owners profess to be “long-term” holders, the industry’s fear is that investors may not easily tolerate poor returns--let alone the 20% to 50% losses that a traditional, drawn-out bear market could bring.

Equally worrisome is the response of portfolio managers to the forces of regression. As competition to attract and retain dollars grows more intense, many U.S. fund managers are already looking to potentially higher-risk securities to beef up returns and gain an edge over rivals.

While some may succeed, the strategy threatens to place more fund managers--and their shareholders--at greater risk of severe volatility and loss than either party may fully understand.

Stock fund managers “are going to be pushing out the envelope in terms of acceptable behavior,” predicts Don Phillips, publisher of fund tracker Morningstar.

It’s Real, All Right

To be sure, the contraction of U.S. stock returns so far in the ‘90s has hardly been disastrous for most funds or their investors, even though the average U.S. general stock fund is down 0.5% year to date.

Still, key market measures show that regression of returns is real:

* An index of 30 major growth stock funds tracked by Lipper Analytical Services has risen 56.7% since Dec. 31, 1989, a period encompassing nearly five years.

If the market holds basically steady for the next three months, the growth fund index’s gain for the first half of the ‘90s will be the smallest for any half-decade period in 30 years, except for the severe bear market period 1970-74.

* Using a broader measure of fund performance--Lipper’s general stock fund average--three of the last five calendar years (including 1994, to date) have produced returns below the 10.3% average annualized total return on the blue-chip Standard & Poor’s 500-stock index since 1925, as calculated by Ibbotson Associates.

* The total return on the S&P; index itself since Dec. 31, 1989, is about 54%, compared to 152% for 1985-89 and 99% for 1980-84 and also for 1975-79.

Although measuring the market over calendar-year periods is naturally arbitrary, it’s worth noting that in each of the aforementioned five-year periods (including the latest) the market experienced both bull and bear phases.

Of course, it isn’t fair to view stocks’ returns in a vacuum. Earning 57% since 1989 has still beaten inflation and bank CDs.

But this year, for the first time since the late 1980s, other investments are providing real competition for stocks. Money market funds, for example, now yield 4.3% on average, and that yield is rising at the fastest pace since 1988. One-year Treasury bills pay 5.9%.

Commodities, including gold, are attracting increasing attention from investors as prices rise with the global economic recovery.

As these rival investments gain altitude, they may challenge the preeminent position that U.S. stocks have held in the public’s mind for the past decade. At the very least, better returns on other investments will act like an unwanted magnifying glass on U.S. stock funds’ shrinking returns.

An Explanation

If regression to the mean is happening in the U.S. market, there should be a fundamental explanation. It’s not enough to say that stock returns should be lower in the ‘90s just because.

Perhaps the most logical explanation is that the phenomenal ‘80s bull market, and its successor in the early ‘90s, were so powerful that they have pushed U.S. stocks to levels that reflect much or all of the good earnings news on the horizon for most U.S. companies.

Even though the United States’ competitive position in the world is again top-rung, the market’s job is to anticipate, Wall Street pros note. That may mean that stock prices, on average, now fairly reflect the U.S. position.

What’s more, the principal force behind stocks’ huge returns since 1980 wasn’t corporate earnings growth, but the worldwide plunge in interest rates, which drove many investors into stocks for lack of better income alternatives. U.S. money market rates declined from 20% to 2.5% between 1980 and ’93.

Now interest rates are climbing again as the world economy revs up. Higher rates raise the cost of doing business (thereby cutting into corporate earnings) and provide new competition for stocks in the form of more lucrative returns on bonds and CDs.

Still, some experts aren’t convinced that lower U.S. stock gains are a fait accompli in the ‘90s.

John Markese, executive director of the American Assn. of Individual Investors in Chicago, argues that while returns should indeed regress over time, the question is what the true historical mean return on stocks really is.

The 69-year average annual return of 10.3% on the S&P; index would be a fine benchmark “if the financial structure of the economy has stayed the same,” Markese says. “But it hasn’t.”

For one thing, U.S. companies are vastly more global in scope today than even 20 years ago; if foreign economies grow faster than the U.S. in the future, as expected, U.S. firms that sell worldwide may reap bigger profit gains than the market now anticipates, and stocks’ returns could be larger accordingly.

“We just don’t have enough data (from the modern economy) to say there’s any kind of pattern in stock returns,” Markese argues.

Nonetheless, the relatively low returns on U.S. stock benchmarks so far in the ‘90s have persuaded many investors to look elsewhere.

“People are scrambling to find investments with higher rates of return,” says Budge Collins, whose Collins Associates in Newport Beach specializes in “alternative” investments for big clients.

The most common route that U.S. stock funds have followed so far is to add shares of foreign-based companies, whose growth prospects may be greater than that of their U.S. counterparts.

In fact, the extent of U.S. fund managers’ international diversification efforts may surprise investors who thought they owned fairly plain-vanilla American securities, Robert Markman says.

The $4.2-billion Twentieth Century Growth fund, for example, while historically a U.S. stock investor, now has nearly a quarter of its assets in foreign stocks. That’s up from 4% a year ago.

“Our charter is still to be a domestic growth fund, but we now have the capability to screen the entire globe (for stocks) the way we would the United States,” says fund co-manager Chris Boyd.

It’s worth noting, of course, that many individuals have been rushing directly into foreign stocks via international stock funds this year, making the same judgment that U.S. fund managers have made: that richer opportunities lie abroad.

In the search for bigger returns, other U.S. fund managers have skewed their portfolios more heavily toward smaller-company stocks. Tom Rowland’s Hummer Growth fund, for example, is about 35%-invested in smaller stocks now, “probably double what it was four or five years ago.”

But where higher returns are expected, by definition the risk is also higher.

Money market funds offer a sobering example of what can go wrong when managers reach for return. Dozens of the funds have suffered sharp losses this year on so-called derivative securities, most of which were purchased to augment the low yields that prevailed in 1993.

For stock funds, the often painful reality is that the more obscure the security--whether foreign or American--the greater the chance that no other buyer will be found if bad news hits. That can lead to abrupt and deep price declines.

A Greater Burden

Morningstar’s Don Phillips views the decision of some U.S. fund managers to chase higher returns as “neither good nor bad by itself.” The issue is whether shareholders of a particular fund understand what the manager is doing--and are comfortable with it, he says.

“What you have to realize as a shareholder is that you may now have a different product from the old blue-chip stock fund,” Phillips says.

Ultimately, all of this puts a much greater burden on individuals to monitor their stock funds more closely. Regardless of how your fund has performed recently, ask yourself a few basic questions to determine whether it is still right for you:

* Does the manager have a clear strategy--and is he or she sticking with it? Perhaps more simply, do you have faith that you have invested with a good stock-picker who can excel in a market where opportunities may be fewer?

* Do you know what kinds of stocks the fund can own and whether its parameters have changed much since you bought?

* Are the fund’s management fees reasonable for the performance you get?

* Are you diversified among different U.S. stock funds--i.e., some higher-risk, some lower-risk? Or are all of your funds too similar in risk characteristics?

* Finally, if the idea of regressing U.S. stock returns causes you Angst, are you diversified enough among other investments (foreign stocks, bonds, real estate, gold, CDs) to assure that your portfolio will usually have something going for it?

How Returns Have Fallen

Despite a rousing bull market since 1990, stock mutual fund gains this decade so far lag results achieved in every five-year period since 1965, except for the bear market period 1970-74. Chart shows performance of a key growth stock fund index.

+67.7% Average return for five-year periods, 1965 to present:

1965-69: +67.1%

1970-74: -34.4%

1975-79: +109.8%

1980-84: +79.7%

1985-89: +127.0%

1990-94: +56.7%

Source: Lipper Analytical Services Inc.