Can Fund Managers Extend First-Half Triumph Over S&P; 500?

Chances are your stock mutual fund beat the Standard & Poor’s 500 index’s performance in the first half of this year.

And that hasn’t happened with much frequency since the early 1990s.

The average domestic stock fund gained 3.5% in the first half, even after pulling back in the second quarter, according to fund-tracker Morningstar Inc.

By contrast, the blue-chip S&P--the; best-known broad-based U.S. share index worldwide--slipped 0.5% in the half, after losing 2.7% in the second quarter ended last Friday.

Those figures count “total return,” or price change plus any dividend income.

For the fund industry, which for most of the late 1990s suffered a perpetual public relations black eye as actively managed fund returns trailed those generated by simply investing in the “passive” S&P; index, the latest performance turn is sweet revenge.

The better numbers turned in by the average fund in the first half stemmed from a number of factors, including stronger performance by small- and mid-size stocks that aren’t part of the S&P; index.

At the same time, the S&P; was hurt by the dive in Microsoft, one of its biggest component stocks, and by weakness in many large financial-services shares as market interest rates rose.

But whether actively managed funds are starting an extended run of beating the vaunted S&P; remains to be seen.

For now, the numbers might hearten fund managers more than many of their shareholders, who are often more concerned with absolute returns than relative ones, and may not see a 3.5% gain as much to crow about.

Importantly, not only did the average stock fund beat the S&P; in the first half, but the better performance was widely distributed in the domestic fund universe: Morningstar’s preliminary data show that 3,650 of the 6,313 domestic funds it tracks, or nearly 58% of the total, beat the S&P; in the half.

In the second quarter, the percentage beating the index was less than a majority, at 44%.

Still, the first-half figure overall is an improvement from the 50.7% of funds that topped the index in 1999, when a fourth-quarter rally in smaller stocks pushed the average stock fund’s return to 27.5% for the year, versus 21% for the S&P--the; first taste of victory fund managers had enjoyed in a while.

Indeed, from 1994 through 1998 the S&P; outperformed the vast majority of funds year after year.

In 1994, for example, just 23.1% of actively managed funds beat the S&P.; That annual figure never got higher through 1998, and in fact reached a low of 7.3% in 1997.

Several factors boosted the S&P; in the late 1990s. One was the ascendance of major technology stocks, which now account for a large chunk of the index--about a third. Managers of many diversified stock funds were late in building large stakes in tech in the ‘90s.

Also, with the Asian economic crisis in 1997, many global investors sought refuge in the biggest, most liquid U.S. stocks, which are the names in the S&P.;

In general in the late ‘90s, U.S. investors had little interest in smaller stocks and the funds that own them--causing a major performance drag on the return of the domestic fund universe overall.

But now, some analysts warn that the soaring performance of many blue-chip S&P; 500 stocks in the late ‘90s has left prices of many of those stocks at levels that may fully discount the firms’ expected earnings growth in coming years.

At the same time, worries about the health of the economy have depressed the industrial sector of the S&P;, leaving stocks in such sectors as railroads and forest-products at 10-year lows.

Add to that the concerns that many big-name tech stocks remain overvalued, and some analysts say the stage is set for the S&P; to lag in coming years, while careful stock-picking by active managers could produce better returns.

“I think the dark days of active management are behind us,” said Kurt Brouwer, a principal at investment advisory firm Brouwer & Janachowski in San Francisco.

The S&P; index has lagged the rest of the market for extended periods in the past, most recently for much of 1992 and 1993.

Still, many financial advisors say the wisdom of sticking with a passive index fund--at least for a healthy chunk of your long-term portfolio--remains sound. If nothing else, by owning the index, you’re guaranteed to get the “market” return over time.

What’s more, the very low expenses charged by index funds--in contrast to the 1% or more that actively managed funds take of shareholders’ assets each year--give index funds a performance edge in the long run.

One key to whether the average stock fund can continue to beat the S&P; is whether smaller stocks stay in favor. Should the economy turn down sharply, many analysts warn that the renewed interest in smaller stocks in the first half might not last long.

Money manager Ken Fisher notes that the greatest risk to the S&P;’s performance is that it could easily be hampered by sub-par returns on a relative few stocks.

Because the S&P; is a capitalization-weighted index--meaning the largest stocks by market capitalization (stock price times number of shares outstanding) matter most in terms of moving the index--a sustained period of trouble for tech stocks like Microsoft, Intel and Cisco Systems, and for other giants such as General Electric, could depress the index even if hundreds of other stocks within it rally.

(That would, of course, just be the flip side of what happened in 1997 and 1998, when those mega-stocks soared at the expense of many other shares.)

Fisher notes that the weighting of the 50 largest stocks in the S&P; 500 was a stunning 60% at the end of last year.

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Return of the Active Manager

Now, stock picking matters again: The average domestic stock mutual fund beat the performance of the passive Standard & Poor’s 500 index last year and again in the first half of 2000. Percentage of funds beating the index:First half 2000:

57.8%Source: Morningstar Inc.