Severe Losses in Equity Funds Test Investors’ Mettle

For most stock mutual fund investors, things went from bad to worse in the third quarter.

The average U.S. stock fund lost 17.6% in the three months ended Friday, the most dismal performance in 14 years, according to fund-tracker Morningstar Inc.

The selling hit not only already beaten-down “growth” stock funds but also most “value” stock funds that had been a safe haven in the first half of the year.

For the first nine months, the average fund skidded 22%. If that figure holds through the year’s end, it will be the funds’ worst calendar-year performance since 1974, when the average loss was 24.9%.

But after 18 months of mostly falling stock prices, many Wall Street pros believe the losses of the last quarter--which deepened after the Sept. 11 terrorist attacks--are more likely to mark the end of this aged bear market than the start of a steep new decline.

Even if there are more losses in the short run, selling stocks now may make little sense for investors whose goals are years away, financial advisors said.

“There are two things we know: Markets cycle, and you can’t predict when they are going to move,” said Phil Edwards, director of fund research at Standard & Poor’s Corp. in New York. “That’s why you have to remain positioned to take advantage when they recover.”

Yet investors’ patience with stock funds is wearing thin. Some data trackers estimate that September will show a third straight month of net cash outflows from the funds--for the first time since 1990.

Heeding the mantra of “stay the course” worked wonders in the last decade, but investors are staring at the possibility of two down market years in a row for the first time since 1973-74, an economic recession, plummeting corporate earnings and a potentially long war between the United States and terrorist forces.

Many investors “are socking money into bond funds and money market funds” rather than be courageous when it comes to stock funds, said Don Cassidy, senior research analyst at fund-tracker Lipper Inc. in Denver.

The level of fear may partly reflect that even longer-term stock-performance numbers now look bleak: The average domestic stock fund has gained just 7.1% a year over the last five years, and the average foreign stock fund has lost 1.1% a year in the period, according to Morningstar.

Some widely held blue-chip funds were severely clipped in the last quarter: Fidelity Magellan lost 15.4% and Janus Fund plunged 25.8%.

This market has been too much even for relatively staid “value” funds with solid long-term records. American Funds’ Investment Company of America hasn’t had a down year since Jimmy Carter was president in 1977, but its winning streak--which Morningstar calls unequaled by any retail fund--could be in jeopardy. The fund is down 11.5% year-to-date.

Legg Mason Value Trust’s record streak beating the blue-chip Standard & Poor’s 500 index for 10 straight years, meanwhile, appears to have better odds of continuing, but manager William Miller is barely winning: The fund lost 20.0% in the third quarter and was down 16.8% in the first nine months, versus a loss of 20.3% for the S&P; 500.

Investors searching for a place to hide in the equity market in the third quarter turned to the most forlorn sector of the 1990s: precious-metals funds, which typically invest in gold and silver mining stocks.

The average precious-metals fund gained 2.4% in the quarter and is up 16.6% for the year, thanks to a rebound in gold and silver prices amid rising global fears of recession and military conflict.

Even so, the average fund in that sector still sports an annualized loss of 13.6% over the last five years.

Funds that bet against the market--such as through “short selling” strategies--were the big winners in the third quarter. David Tice’s Prudent Bear, one of the better-known bearish funds, surged 41.5%. ProFunds UltraShort OTC and Rydex Arktos also rocketed, though these funds, by design, will plunge if the market rebounds.

Analysts say such funds can be effective as a hedging tool because they offer protection in a downdraft, but they are generally shunned as longer-term holdings because they fight the market’s historical upward trend.

If something good can be said for this long bear market, it’s that it has been a continuing advertisement for portfolio diversification, financial advisors say.

Despite last quarter’s losses, value-stock funds generally have held up better than growth funds, the darlings of the late-1990s.

Real estate-related funds posted modest losses in the quarter but still are up 4%, on average, year-to-date.

“Diversification was something people snickered about in a straight upward market” dominated by blue-chip growth stocks, Cassidy said. “Not anymore.”

The bear market finally caught up to small-cap funds, which lost ground as a group in the third quarter, but they have fared batter than their blue-chip counterparts this year.

“This bear market may be waking some people up, getting them to ask, ‘Am I positioned correctly?’ So if someone is doing [asset] reallocation based on that, then that’s great,” Edwards said.

On the other hand, many foreign stock funds followed the U.S. trend in the third quarter, leading some investors to again question the diversification benefits of buying abroad.

Foreign funds sank 16.2% in the quarter and are down 28.0% year-to-date, on average.

A big chunk of the stock fund redemptions in recent months has come from foreign funds, according to the Investment Co. Institute, the industry’s main trade group, and other data trackers.

For stock fund investors looking to take advantage of recent market weakness, Edwards believes the large-cap value category still is a good place to look.

“There’s something to be said for the relative safety of large-cap stocks, and value makes sense because there are a lot of bargains out there now,” he said.

Value funds typically focus on stocks selling for low prices relative to underlying earnings or net worth.

But Edwards advised shying away from “deep value” funds, whose bargain-basement portfolios have done well lately but might not be positioned to take full advantage when the economy starts humming again.

Two large-cap value names Edwards likes from S&P;’s “Select List” of 35 funds are Legg Mason Value Trust and Selected American Shares, which is down 20.1% this year. Legg Mason manager Bill Miller and Chris Davis, who manages Selected American, “have both shown the ability over the years to find good stocks that are out of favor and eventually bounce back,” Edwards said.

So-called dollar-cost averaging, or investing on a regular monthly basis, could be the best approach for those looking to buy stock funds now, analysts said.

“It’s almost impossible to pick the absolute bottom, and if you’re waiting for clear evidence of a new bull market you’re going to miss 1,500 points on the Dow,” Cassidy said. “If you’re betting it all on one horse, well, what if that horse had been named September?”

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Josh Friedman can be reached at josh.friedman@latimes.com.

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TOP-RATED STOCK FUNDS

Stock funds, ranked according to a system developed by The Times and fund tracker Morningstar Inc., are listed in more than a dozen categories beginning on S6.

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3rd Quarter’s Best, Worst Equity Performers

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Stock Fund Performance by Morningstar Category

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