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Posted 12/27/2001
  Related links Check our mutual fund directory Research mutual funds Use our fund screener See if your fund is one of the hot funds Take our retirement IQ test Investors get help in sizing up funds Mutual Funds Recent articles: • Small victories and big lessons from 2001, 12/18/01 • Where bond investors turn for yield, 12/11/01 • Tech's biggest losers aren't apologizing, 12/4/01 more... |
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The funds to own in 2002 -- and 2007 The easy money has been made and lost. Now, successful funds will be those whose managers understand how to pick stocks and bonds carefully and know when to buy and sell. By Timothy Middleton The era of double-digit returns is not over. But the glory days of index funds are. Successful investing in the next year, indeed, in the next five years, will be quite different than it was in the last five. The vaunted Standard & Poor’s 500 index ($INX) is in tatters, with no less a seer than Warren Buffett predicting it will return no more than 7% annually for years to come. The lengthy bull market in Treasury bonds has snapped like an arthritic bone. Indexing has surrendered leadership to tire-kicking stock pickers.
“I think we can do 10% to 12% compounded through the next five years,” says Steve Leuthold, manager of Leuthold Core Investment (LCORX), one of the industry’s most successful funds over the last two years. But earning those returns won’t be easy. “Market timing or asset allocation is going to be much more of an important discipline than it was through the big bull market,” he says. Investors in the years to come will prosper by moving aggressively away from most -- but not all -- of the last decade’s winners, and by shifting opportunistically and regularly among the new market leaders. These will include:
The case for small caps The sea change in markets is most vividly demonstrated by the crushing of the S&P 500. The remarkable growth in that benchmark in the latter half of the last decade helped make Vanguard 500 Index (VFINX) the largest mutual fund in the world. But whereas the bear market eviscerated the index -- the Vanguard fund’s pretax return in the three years ended Dec. 25 was -1.07%, the famously-managed Legg Mason Value fund (LMVTX) managed to stay ahead. For the same period, it's up 2.3%. (Both would have done far worse without splendid gains in 1999.) “The problem with capitalization-weighted measures like the S&P is that even now it is overvalued by historical valuation parameters, whereas small- and mid-cap stocks are about normal,” says Leuthold. Even after the bear market, the 500 index was trading at nearly 46 times trailing earnings as of mid-December. Small caps, on the other hand, have prospered. In the 12 months ended Nov. 30, the average small-cap fund in Lipper’s so-called core (a mix of growth and value) category advanced 10.7%, compared with a slide of 13.5% for big-cap core. That outperformance is likely to continue. “Coming out of a recession, small-cap growth is probably the sector that would lead the way,” says Ned Notzon, head of asset allocation for T. Rowe Price. What’s more, he adds, “The cycles in small-cap growth are quite large -- eight or nine years.” Wiener likes mid-cap stocks even more, because they represent the most successful small caps still early on the road to becoming giants. “When you own 4% of a market, there’s 96% left to go,” he notes. “If you can grab on to another 1% or 2%, you can grow exponentially.” Academic research indicates that active portfolio management tends to beat indexing in small-cap investing, because information is relatively harder to come by and well-informed managers have an edge. Burton Malkiel, author of “A Random Walk Down Wall Street,” has found that indexing is most successful with big-cap stocks. But even actively managed big-cap funds such as Magellan have beaten indexing lately. In the 1990s, the Vanguard fund consistently beat about 80% of its rivals in Morningstar’s big-cap blend category. This year, it is beating fewer than 60% of them -- 342 of the 557 distinct portfolios in that database. For a screen of the funds that fit this line of thinking, click here. Do emerging markets represent opportunity? Emerging market stocks are emerging as a global value, largely because in much of the developed world, and not just the United States, stocks remain richly priced. According to Julius Baer Investment Management, German stocks are trading at 63 times trailing earnings, and English equities around 32 times. By contrast, the P/E ratio on Mexico’s Bolsa is less than 15. In Hong Kong, it is slightly above 15. Emerging markets have been a money pit for most of the last decade, with the average fund ahead a miserly 2.4% annually, according to Lipper. But in November those funds jumped an average of 10.1%. “In places like Thailand, mainland China, Taiwan and Korea, we see potential economic growth rates of 7% to 7.5%,” says Leuthold. “I think you can make some pretty good returns there.” For a screen of the funds that fit this line of thinking, click >here. The bond market still looks good Corporate bonds have also been stronger than Treasurys lately. The latter are purely subject to interest-rate risk, and if the United States emerges from recession soon, as is widely expected, rates will stop going down and eventually will start going up. The strongest corporates have been junk bonds. They were battered ahead of the recession as the default rate soared above 10%, but a strengthening economy will send the fortunes of their issuers the opposite way. The bonds themselves have already begun responding to this expectation. In November, they were by far the strongest fixed-income group, with the average fund gaining 3.1%, according to Lipper. Treasury funds declined 3.4%. For a screen of the funds that fit this line of thinking, click here. Tech and health care: too big to ignore Two of the three strongest sectors of the 1990s were technology and health care, and they are likely to continue their leadership for at least the next five years. The cyclical downturn in tech stocks has already ended: In November, technology was the best-performing sector, with the average fund in the group shooting up 15.9%. The remarkable economic growth of the 1990s was largely due to productivity improvements wrought by high-tech software and systems. “I don’t think anybody believes those improvements can’t be increased,” Wiener says.
Return to the '70s? The market landscape in the years to come is apt to look a lot more like the 1970s than the 1990s. Back then big-cap stocks -- the infamous Nifty Fifty, which included Burroughs, Polaroid (PRDCQ, news, msgs) and Kmart (KM, news, msgs) -- collapsed in ashes, and small caps enjoyed their greatest period of outperformance in history. Interest rates started low and then began to soar, along with oil prices and inflation. S&P index funds didn’t come along until after the crash of 1973-74; Vanguard’s portfolio was born in 1976. But if they had existed before the crash, they would have plunged their shareholders into a hole from which they would not have emerged until about 1983. The '70s were also the heyday of active portfolio management. So will be the next five years. And the most active manager will be the individual investor, because these groups won’t move inexorably higher in lockstep. The successful investor will take profits from the groups that get ahead of themselves to deploy in the underachievers. It’s still long-term investing; it’s just not no-brainer investing. At the time of publication, Timothy Middleton owned none of the securities mentioned in this article 
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