Reversal of Fortune for Most Stock Funds

Hopes for a record fifth straight year of double-digit U.S. stock fund returns dimmed considerably in the third quarter as most fund categories slumped.

In the three months ended Sept. 30, the average domestic equity mutual fund fell 5.5%.

Year to date, the average fund now is up just 5.1%--far below the 17.9% average annualized gain of the last five years, according to fund tracker Morningstar Inc.

All told, 19 of the 28 stock fund categories tracked by Morningstar lost money in the third quarter.

Compare that with the second quarter, when every stock fund category gained ground in a broad rally that even lifted such long-depressed sectors as smaller stocks, value stocks and emerging markets.

As quickly as those beaten-down sectors had resurged, many headed back into the negative column in the third quarter, weighed down by rising interest rates, soaring commodity prices and other concerns that turned investors skittish.

Still, while most funds lost money in the quarter, it was far less harrowing a period than the third quarter of 1998--when the average U.S. fund tumbled 15.2% amid Russia’s currency devaluation and the then-continuing Asian economic crisis.

In that quarter, every stock fund category but precious metals lost ground. In the latest quarter, there were at least a few more opportunities to make money.

The average Japan stock fund, for example, zoomed 20.5% in the quarter and is up nearly 68% year to date on rising hopes that the world’s second-largest economy is emerging from a decade of woe.

*

Likewise, diversified Pacific-Asia stock funds that had a hefty percentage of assets in Japanese stocks did well, boosting that category 7.7%, on average.

Those third-quarter Japanese gains, though, were mostly currency-driven, as the yen strengthened considerably against the dollar. In fact, in yen terms, the Nikkei-225 index of blue-chip stocks was up less than 1% in the quarter after surging 27% in the first half.

As the yen rises in value, however, Japanese stocks owned by U.S. investors automatically appreciate in dollar terms, because the same amount of yen buys more dollars.

Yet that strong yen also threatens Japan’s recovery by hurting its exporters. Those concerns helped trigger profit-taking in other Asian stock markets that had zoomed in the first half, leaving the average Pacific-Asia fund that excludes Japanese stocks down 6.5% in the quarter.

Meanwhile, the weak dollar helped returns on general foreign stock funds and Europe-centered stock funds, which rose 4.2% and 0.2% in the quarter, respectively.

And while soaring oil prices have been no fun at the gas pump, they’ve kept investors interested in energy stocks--whose strength helped lift natural resources stock funds 2% in the quarter, on average.

Renewed interest in commodities also added some sparkle to the worst-performing fund category of the decade: precious metals funds.

Those funds soared 18.7%, on average, in the quarter. But nearly all of that gain came in the final days of the quarter, as gold prices shot from $255 to $308 an ounce following assurances by European central banks that they would cap gold sales over the next five years.

Perhaps the biggest surprise in the quarter was that investors made more money in technology stock funds, which rose 8% on average, after leaping 34.4% in the first half. Despite concerns entering the quarter that rising interest rates would hurt stocks selling for high price-to-earnings ratios, tech proved largely impervious.

In fact, despite some notable blue-chip exceptions, growth stocks--shares of tech companies and others expected to post above-average earnings growth--held up remarkably well in the quarter.

The average large-cap growth fund slipped 3.6%, while the average small-cap growth fund actually rose 1.1%. By contrast, the average large-cap value stock fund tumbled 9.6%, and the average small-cap value fund slid 7.1%.

Value stocks--shares of companies that are beaten-down, overlooked or simply slower-growing--were dragged down again for several reasons, analysts say.

For one thing, a traditional value play is the financial sector. The average large value fund invests nearly 25 cents of every dollar in financial stocks, or twice what large growth funds invest in that area.

Rising interest rates and worries about banks’ loan quality hammered the financial sector in the quarter. That was evident in the 12.9% average decline in financial services stock funds--the quarter’s worst-performing category.

“That’s what has caused some value managers to underperform,” said Robert Rodriguez, manager of the $555-million value-oriented FPA Capital fund.

In particular, funds that invest in mid-size value stocks suffered because that sector has a significant concentration of financial stocks.

Another classic value play--real estate stocks--also slumped. The average real estate fund lost 9.4% in the quarter.

While the debate rages on Wall Street over how high is too high for growth stocks--and whether value stocks are ridiculously cheap--some analysts say some investors’ preference for growth may be signaling that they’re worried about an economic slowdown.

If business slows, shares of companies that can post strong growth could be all the more in demand.

Some experts say the weakness in Latin American stock markets in the quarter--down 10.2%, on average--also may have been partly blamed on concerns that heady U.S. economic growth will give way to a slowdown sooner than later.

If there was one heartening trend in the U.S. market in the quarter, it may have been the relative strength of smaller U.S. stocks--or at least those owned by small-stock mutual funds.

Small-cap growth funds beat mid-cap and large-cap growth, and small-cap value held up better than mid-cap and large-cap value.

Those small-cap returns helped raise the percentage of domestic funds that held up better than broad market indexes in the quarter.

“I find this encouraging,” said Michael Lipper, head of fund tracker Lipper Inc., because it suggests the broadening of interest in the market in the second quarter didn’t reverse completely.

Paul J. Lim can be reached at paul.lim@latimes.com.