July 3, 2002 — Mutual funds focused on defensive sectors of the market continued to outperform in the second quarter as new allegations of accounting fraud and news from WorldCom (WCOM) helped to push stock indexes to new lows for the year.

Gold and precious-metals funds, already strong performers in the first quarter, added to their gains in the second quarter as terrorism fears and a weakening U.S. dollar also heightened investor uncertainty. The average gold fund is up 65.7% so far this year after rising 36.8% in the first quarter.

Real-estate funds, also a defensive play with their dividend-paying REITs backed by tangible assets, are up 12.4% on average as of mid-year, followed by funds investing in natural resources, up 5.5%. Sector funds investing in financials are up slightly, 0.5% so far this year.

In contrast, funds investing in technology, telecom, health care, and biotechnology stumbled the most in the second quarter as the Nasdaq came close to the lows it saw following the terrorist attacks last September. The average tech fund lost 34.3% through June 21, while funds investing in telecom and communications lost 35.8% on average. The average health care fund was down 24.7% as of mid-year. A representative sampling of biotech funds by Standard & Poor’s showed average losses of 44.6%.

Precious metals

As losses in aggressive sector fund categories became much steeper in the second quarter, gold funds continued to rise as the price of gold climbed to the $320 level. The best-performing among gold funds as of mid-year include US Global Investors Fds:World Prec Minerals (UNWPX), up 92.1%, US Global Investors Fds:Gold Shares (USERX), up 82.1%, and First Eagle SoGen Gold Fund (SGGDX), up 79.7%.

Though all gold funds are up strongly so far this year, the top performers largely avoided shares of gold mining companies that hedge the price of gold, instead emphasizing mining shares leveraged to the price of gold. Funds that diversified out of gold mining companies, or had more exposure to metals tied to the industrial cycle, didn’t rise as much as did the more pure-play offerings on gold.

Frank Holmes, chief investment officer of US Global Investors, sees the fundamentals driving gold and gold shares still in place: falling mine output and exploration, the weakening dollar, and rising deficit spending. He continues to recommend a 5% weighting in gold. Though some gold fund managers believe gold and gold-related assets will continue to outperform other financial assets, seeing a mutli-year bull market for the metal, not every quarter will be up.

Real estate

Real estate funds rose in the second quarter, aided by relatively stable income producing REITs, but the strongest performers, such as Alpine US Real Estate Equity Fund/Y (EUEYX), continued to take a sizable stake in stocks of home-building companies. The Alpine US Real Estate portfolio has risen 26.8% so far this year. CGM Realty Fund (CGMRX), another strong performer with a sizable stake in home builders, is up 24.4%. Most real estate funds, however, more heavily invested in REITs, saw returns in the 10%-12% range.

Going forward, Sam Lieber of Alpine Real Estate Equity, believes the strongest gains in the sector over the next 12 months will continue to come from home-building stocks, which he sees as undervalued by 50%. His fund can swing, depending on where he sees the best opportunities in the real estate landscape. The portfolio is currently 35% in REITs, which Lieber thinks could be up another 5%-10% going forward to the end of the year. “What has been working lately is not the big cap super-liquid names where you need a lot of capital drive, but the smaller-cap plays, and that tends to be more real estate companies,” he notes.

Energy & Natural resources

Though funds investing in energy and natural resources pulled back in the second quarter after doing well at the start of the year on higher commodity prices, they still registered gains as of the end of June, up 5.5% on average. Some of the outliers include Prudential Natural Resources Fund/Z (PNRZX), up 23.3% as of mid-year, and Ivy Fund:Global Natural Resources/Adv (IGNVX), up 17.3%. Both funds take a broader approach to investing in resources, and were aided by exposure to precious metals as well as to energy services companies, which helped in the first quarter.

Manager Fred Sturm of Ivy Global Natural Resources has been increasing his exposure to energy stocks and trimming his exposure to gold of late. “When we drill down to a company level, the resource producers are still in fine shape,” says Sturm. “They are basically all still making money, and basic industries are all still holding firm and showing a tendency to outperform the market and to hold better than other sectors.” The fund’s energy weighting is currently 55%-60%. One area the Sturm is currently interested in: the opportunity in electricity producers and energy generators, shaken after the fallout following Enron.

Financials

Sector funds investing in financials were up just 0.5% as of the end of June, pulling back in the second quarter after being shaken by bad news and market declines. FBR Small Cap Financial Fund/A (FBRSX), a top performer, rose 19.5% as of mid-year by continuing to focus on small-cap regional banks and thrift institutions. Diamond Hill Bank & Financial Fund/A (BANCX), also a strong relative performer, is up 16.2% over the same period. The top performer in the group was Emerald Select Banking & Finance Fund/A (HSSAX), which rose 19.8%.

Although manager David Ellison of FBR Small Cap Financial can buy anything in the financial services sector, small banks and thrifts are attractive because they have uncomplicated business models, generate fairly predictable earnings, and are less risky than large-cap financial companies right now since they make safer loans at smaller balances. “If you are making money in middle America, it doesn’t change that much,” says Ellison on the characteristics of his holdings. “The middle of America doesn’t go bankrupt, it doesn’t become overvalued.”

Technology

Tech funds were down 34.3% on average as of mid-year, achieving most of the losses — roughly 30% — during the second quarter as the market deteriorated and punished aggressive growth-oriented segments of the economy. The best relative performers as of the end of June included Matthews Asian Technology Fund (MATFX), which fell 7.2%, Franklin Custodian Fds:DynaTech Series/A (FKDNX), down 12.4%, and Kinetics Internet Emerging Growth Fund (WWWEX), down 17.7%. Kinetics Internet Fund (WWWFX) also made the list of the five best relative performing tech funds, losing 17.8%. Losses for most tech funds, however, were severe.

Matthews Asian Tech, which invests across Asia, including China, benefited in the first quarter from the anticipation of a recovery in the U.S., and has been aided by stronger domestic demand for technology in Asia versus the U.S., notes Paul Matthews, chief investment officer of the Matthews Funds. Going forward, Matthews believes that the outlook for domestic demand in Asia is still clearer than in the U.S. He is more confident that high tech firms in Asia will continue to sell products into the Asian markets than he is of a strong recovery in export demand, while the U.S. will need to see a pickup in corporate spending in order to recover.

Health & Biotech

Funds investing in health care and biotech also have shown steep losses so far this year. The average health care sector fund fell nearly 25% as of the end of June, dragged down, in part, by biotech shares. Biotech funds, in particular, have been some of the hardest hit portfolios this year, many losing over 40%. “The biotechs, I believe, are sort of a hostage to the Nasdaq,” notes Alidad Mireskandari of Orbitex Health & Biotechnology/A (ORHAX), which lost 33.5%. The fund’s weighting in both biotech shares and big pharmaceutical stocks were a drag in the second quarter.

The best relative performing health care funds so far this year include ICON Healthcare (ICHCX), which rose 1.1%, and Vanguard Health Care (VGHCX), which lost 6.5%. ICON Healthcare achieved gains in the sector by avoiding both large-cap pharmaceuticals and biotech shares, focusing instead on health care services, including health care facilities and managed care distributors and suppliers.

The managed health care industry has continued to perform well recently, notes James Callahan, chief investment officer of Meridian Investment Management, advisor to the ICON funds. Callahan says he expects the fund to remain invested in the same industries over the next five months or so. Though he is finding some large-cap pharmaceuticals on sale, he doesn’t believe it is their turn to outperform yet.

Note: Sector fund averages are as of 6/21/02 — latest available at this writing.