Mutual funds that focused on small and mid-size stocks led in first quarter

Mutual funds that focus on small and mid-size stocks were at the top of the leader board in the first quarter. That’s a classic bet on a stronger U.S. economy, because smaller firms tend to be more dependent on the domestic economy for their sales and earnings -- as opposed to blue-chip companies that operate world- wide.

Funds that own small-capitalization value stocks -- shares believed to be undervalued relative to a firm’s earnings or assets -- recorded a total return of 9.3%, on average, according to Morningstar. Total return includes share-price appreciation as well as any dividend income. Mid-cap value funds were up 8.1%.

By contrast, the total return of the Standard & Poor’s 500 index of big-company stocks was 5.4%.

Market bears argue that smaller stocks’ continued strength is a sign that the rally is getting frothier: Thinly traded small-cap shares are a fertile field for speculators who often run wild just as bull markets flare out.

Among specific fund sectors, the top performers in the first quarter were an eclectic mix:

* Real estate funds, which typically own shares of real estate investment trusts, surged 9.4%, on average, bringing their gain for the last 12 months to 105.3%.

Some investors may have been betting that the worst-case scenario for commercial real estate prices already was reflected in beaten-down REIT shares. Despite the gain of the last 12 months, the average REIT stock still is down 43% from the sector’s 2007 peak, while the S&P 500 is off 24% from its 2007 peak.

* Financial stocks, which, like real estate issues, were devastated in the market crash, got a second wind in the first quarter, lifting the average financial sector fund 9.2%. That followed a 1.2% average decline in the fourth quarter.

* Funds that focus on healthcare stocks rose 6.2%, on average, as investors overcame their fears about the sweeping industry overhaul that the Obama administration pushed through Congress. Healthcare was one of the weakest stock sectors in 2009.

* Japanese stock funds beat all other foreign fund categories, gaining 7.1%. Japan’s rally, like Wall Street’s advance, was led by small-company issues.

But much of the rest of the world was a disappointment to U.S. investors. Europe-focused stock funds added just 0.9% in the quarter, held back by worries about Greece’s fiscal mess and by the damage that did to the euro: The European currency’s decline against the dollar meant that any stock gains in European markets were worth fewer dollars for U.S. investors.

The troubles in Europe hurt some of the biggest foreign-stock funds, which tend to be heavily invested there. The popular Harbor International fund eked out a minuscule gain of 0.6% in the quarter.

Diversified emerging-markets funds, meanwhile, were held back by the dollar’s strength against currencies such as the Brazilian real and by weakness in some Asian markets tied to China’s efforts to slow its economy.

The average emerging-markets fund added 2.7% in the quarter after soaring 74% last year.