Risk Takers Reaped Sizable Rewards

Mutual fund investors navigating the stock market’s choppy waters during the third quarter found that it paid to take a few chances.

During a period when the average fund investing in U.S. stocks notched a respectable total return of 4.5%, according to data tracker Morningstar Inc., funds that invest in the riskier corners of the market -- technology, small-company stocks, gold-mining shares, Japan -- did considerably better.

Risk was so much in vogue that some market players were sensing troubling signs that mutual fund investors were starting to display some of the speculative behavior that marked the final throes of the 1990s bull market. In particular, the resurgence this year of technology stocks is evoking bad memories for some fund managers.

“Maybe it’s our contrarian nature, but we’re getting increasingly cautious,” said Tim Fidler, director of research at Ariel Capital Management Inc. in Chicago, which runs the value-oriented Ariel Funds. “People are buying stocks that are more speculative in nature, companies with weaker balance sheets and, often, no earnings. It’s not supported by the fundamentals.”

But this year’s rally has been far broader than the tech-dominated boom of the late ‘90s. For example, precious metals funds were the best-performing sector in the third quarter with an average total return of 25.5%, according to data from Morningstar in Chicago.

And fund investors who bet on foreign stocks -- especially Asian shares and stocks of smaller foreign companies -- in the latest quarter generally saw returns that topped U.S. market gains.

Indeed, international stock funds posted an average return of 9.1% in the quarter, double the performance of their domestically oriented brethren. Foreign funds were helped by the weaker dollar, which boosts the value of foreign shares when translated from stronger currencies.

On the home front, investors who wagered that the U.S. economy was still in growth mode, despite uneven evidence of the health of American business, have been well rewarded this year.

Funds that invest in growth companies, which tend to perform better during times of economic expansion, fared better during the quarter than value funds, which typically seek out undervalued stocks.

Worries about the direction of the economy dogged the market throughout the quarter, which was one reason the average domestic stock fund’s return was well behind the 17% recorded in the second quarter.

Nonetheless, “The major theme is that it looks like the economy is going to turn around,” said Don Cassidy, senior research analyst at fund tracker Lipper Inc. in Denver. “It’s not going to be roaring, but there is building confidence that the worst has been seen.”

Here is a look at some of the notable fund performance trends in the quarter, and their prospects for continuing:

* Small was in, but big wasn’t bad. Funds that invest in small-company growth stocks outperformed large-company growth funds in the quarter, with an average gain of 9.1% versus 3.4%, according to Morningstar.

In general, smaller, more nimble companies are seen as best positioned to take advantage of an improving economy.

“When a couple of small orders come in the door,” Cassidy said, “that’s much more meaningful to a little company than to a General Electric.”

But even some money managers who specialize in smaller stocks are worrying that shares in the sector may be getting overpriced, given that smaller stocks have outperformed bigger stocks for most of the last three years.

“A year ago, small-cap names were drastically undervalued. That’s corrected itself over the last 12 months,” said Jim Oberweis, whose Oberweis Emerging Growth Portfolio surged 55.3% in the first three quarters. Bargains still can be found, but not as plentifully as a year ago, Oberweis said.

* Deja vu: Tech was hot. The average tech fund gained 10.6% in the third quarter and 37.4% in the first nine months, according to Morningstar. Opinions are divided as to whether that’s a healthy pattern for the market or a scary one.

Fritz Reynolds, whose Reynolds Blue-Chip Growth fund in Larkspur, Calif., rallied 26.2% in the first three quarters after getting walloped during the bear market, said tech sector fundamentals were improving. He pointed to a Semiconductor Industry Assn. report last week showing that global chip sales rose 12.5% in August, the sixth straight monthly gain.

“What’s happening is pretty textbook. Tech stocks do well at this stage of an economic turnaround,” Reynolds said. “Semiconductor spending tends to pick up early in the cycle because it’s a low-priced product [for businesses].”

Fidler, however, said companies were telling Ariel that capital spending might not improve meaningfully until the second half of 2004.

“Technology is one of the pockets of speculation where valuations are stretched,” he said. “It’s time for the fundamentals to catch up to these stock prices.”

One bright note for tech: With the gains of this year, tech funds’ average annualized return for the last five years now is back in the black -- though it’s a measly 1.1%, compared with 4% for the average domestic stock fund.

* In real estate they trust. The average real estate fund returned 9.1% in the third quarter, bringing the sector’s year-to-date gain to 24.7%.

Some of the funds are rallying like tech funds circa 1999: Manager Ken Heebner’s CGM Realty, for instance, rocketed 55% in the first three quarters.

This for a category normally coveted mostly for its steady income production.

Lipper’s Cassidy said the funds, which typically hold shares of real estate investment trusts as well as home builders and other real estate companies, are benefiting from several factors that could continue. For one thing, investors still feeling snakebitten by the market downturn hope to minimize risk by buying income-paying shares such as REITs.

What’s more, if the U.S. economy is truly on the upswing, Cassidy said, that could mean fewer vacancies and higher rents for commercial and industrial REITs. The recent bump in mortgage rates makes housing less affordable, which could work to the benefit of apartment REITs, he added.

* Precious metals: good as gold. This isn’t your father’s gold rally.

“Normally, gold is a hiding place when you’re scared or when you see lots of inflation,” Cassidy said. Certainly, international tensions remain high, but they’ve eased from the levels of late 2001 or the weeks leading up to the Iraq war. And inflation remains tame.

These days, the precious metals industry may be benefiting from improving fundamentals, he said, pointing to the consolidation of recent years that has made gold-mining firms more efficient.

Performance-chasing by investors could be boosting gold stocks as well. “A lot of folks are jumping on whatever’s hottest at the moment,” Cassidy said.

Long-term returns have been less golden. The average precious metals fund has gained an annualized 1.7% over the trailing 10 years, lagging behind most fund categories.

However, the near term has been more rewarding. While the long bear market was battering other equity mutual funds, precious metals funds have posted an average annualized return of 14.9% over the last five years -- the best of any Morningstar stock fund category.

* A Japan resurgence -- at least for now. Japan, the worst-performing category of the last 10 years, could be in the midst of a historic turnaround -- or yet another in a long series of head fakes. Japan’s Nikkei 225 stock average is up a nifty 25% year to date; on the other hand, at Friday’s close of 10,709, it’s far from its all-time peak of 39,000 in 1989.

Japan-stock funds may be getting a lift for good reason, analysts say. Gross domestic product growth has risen in Japan for six straight quarters, although not dramatically, and consumer spending is on a modest upswing too.

“Maybe this time it’s for real,” Cassidy said.

For U.S. investors, the strong yen provides an added boost -- though it also threatens to hurt the export prospects of Japanese companies.

Investors have seen brief rallies in Japan several times since 1989, only to see the Tokyo market collapse to new lows.

The current Japanese market rally may not be sustainable, Morningstar senior fund analyst Gregg Wolper said in his third-quarter review.

“The occasional rally has briefly brightened the mood in recent years, but each has soon fizzled,” he said.