From the February 2006 issue of Investment Advisor • Subscribe!

Silk Purses

Medal winning fund managers in 2005 drilled for returns and explored overseas

The average mutual fund investor made money in 2005. Perhaps not as much as in 2004, but positive returns were the norm, nonetheless. On the horizon are signs of change suggesting that while the equity markets got off to a booming start in the first two weeks of 2006, finishing well this year may be trickier than it was in 2005. It seems 2005 was more about reverting to the mean, and less about value versus growth or large cap versus small cap. In fact, in 2005 mid-cap funds beat both large-cap and small-cap average fund returns for U.S. equity funds; but sector and international funds led the way to the really big returns for 2005, according to Standard & Poor's.

All of Standard & Poor's broad equity fund categories--and most fixed-income categories--finished the year with positive returns. But if you compare the 2005 average returns with those from 2004, returns in all categories were lower in 2005. In this year's list of the best funds in each S&P category, total returns ranged from a high of 57.19% from the BlackRock Global Resources fund to a not-so-low return of 5.49% for the Regions Morgan Keegan Select Intermediate Fund (see Best of Breed chart below).

Part of the reason returns cooled in the domestic equity markets is concern about earnings. "Last year was a record for earnings and we're predicting another record this year, but there's always more anxiety about the sustainability of earnings growth as you get later in the cycle; that can lead people to get more defensive, go toward higher quality," says Alec Young, equity market strategist at Standard & Poor's.

Another reason that domestic equity markets lagged in 2005 is that interest rates and oil prices are taking a toll on consumer spending, which led to slower GDP growth in 2005 than in 2004, something Robert Doll, president and CIO of Merrill Lynch Investment Management in New York, expects to continue in 2006. As consumers spend a higher percentage of their disposable income on interest payments, and energy, it "crowds out their ability to spend on other things," says Doll. Meanwhile, corporations are rich in cash, so Doll expects capital spending to remain relatively strong in 2006. He predicts earnings growth in 2006 to be about 5% to 7%, or half of the consensus estimates.

For fixed income, as short-term interest rates were lifted by the Federal Reserve, a lack of new supply squeezed the long end of the bond market, pushing long-bond yields down. The market flirted with an inverted yield curve, which often presages economic slowdown or recession. One notable result of these mixed signals was that the average tax-free municipal bond fund actually returned a shade more, up 2.36%, than all other broad fixed-income categories--except for high-yield corporate bonds--which beat the average tax-free fund by a whopping 30 basis points, at 2.63%.

Good News, Bad News

The best performing fund in any of S&P's categories for 2005 is the $41 million BlackRock Global Resources Portfolio/Institutional (SGLSX) and those who own it are sitting pretty with a 2005 total return of 57.19%. It is the top fund in the Equity Sector category, which had an average return of 11.66%. Within its fund peer group, the average return was 44.25% for 2005. What could be bad about that? Well, this fund is now closed, so under most conditions if someone doesn't already own it, they can't currently buy it.

The Equity International category had the best average return for 2005, up 15.32%, and the best performing fund in the category is the $206 million American Century International Opportunity, (AIOIX), returning 36.45%. The American Century International Opportunity Fund is also closed to new investors.

The Cap Difference

Although value funds topped growth on average in 2004, in 2005 growth funds pulled slightly ahead at 6.87% versus value funds' 6.52%. But within the value and growth categories, capitalization tells an important part of the story. Mid-cap blend funds surpassed all the others with a 9.65% average return, with mid-cap growth nipping at its heels with 9.60%, followed by mid-cap value funds at 9.07%. Among small caps there was almost a photo finish. Small-cap growth funds won by a nose, with 6.35%, small-cap value funds were next at 6.17%, and small-cap blend funds returned 6.06%. For fans of large-cap, large-cap growth funds returned an average 5.96%, while large-cap value funds made 5.74%, and large-cap blend finds returned 5.34% on average.

From these numbers one might reasonably ask if we've reached the point in regression to the mean where value tips toward growth, and growth catches value. As advisors rebalance, Young says, it's not time to jettison all the small- and mid-cap stocks or funds--though paring back may make sense, and then use some of that capital to increase the allocation to large-cap holdings.

The leader in the value category is CGM Capital Development (LOMCX), with a 25.28% total return for 2005. Its style peers are mid-cap value funds. The top growth fund, Morgan Stanley Aggressive Equity/D (AEQDX), returned 22.72% in 2005.

Spotlight on IA

Each month, Investment Advisor selects a fund to profile. While we realize that there's much more to selecting funds that are suitable for clients' portfolios than performance, we thought we would see how the Investment Advisor Mutual Fund Spotlight picks did in 2005. Total returns for the funds and managers IA profiled range from a 51.85% return to a loss of 1.55%. Of the 11 funds we spotlighted, eight had higher total returns than their peer group's average return, while three funds underperformed their peers. The average total return for the 11 funds in the Spotlight group was 19.85%, and the average for all of their peer groups was 17.15% (see table below.)

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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