Despite reports that the bull had reared his head again, a possible war in Iraq, corporate scandals, and a lackluster economy kept investors at bay during the first half of 2003. But by the second and third quarters, with the U.S. invasion of Iraq in full force, investors became more optimistic that there would be an economic rebound, and headed back into the markets.

The second half of ’03 also saw a flowing of funds back into equity funds, notes Rosanne Pane, a mutual fund strategist at Standard & Poor’s. “People were willing to take on more risk [in the second half of last year], and that’s why there was a movement toward technology, especially the mid- and small-cap segments,” she says.

Scanning the list of our best-performing funds of 2003, prepared for Investment Advisor by Standard and Poor’s, two funds reaped phenomenal rewards by investing heavily in technology. The number-one fund, Apex Mid-Cap Growth Fund, turned its -42.40% return in 2002 into a whopping 165% return in 2003. At the end of March last year, 72% of the fund’s portfolio was invested in technology, Pane says. The Dreyfus Growth and Value Fund had 21.9% of its portfolio devoted to information technology at the end of September ’03, Pane says. (The S&P 1500 sector indexes show that information technology was up 47% last year.) Such a large position in technology, atypical of most small-cap value funds, helped the fund garner an 87% return.

Small-cap funds were the stars in ’03, outperforming their large-cap rivals by a substantial margin, according to S&P. The average small-cap fund returned 43.16%, 15% better than the average large-cap fund, S&P says. But S&P expects large-cap funds to take the reins in 2004. “Large-cap funds tend to do better in the second year of a bull market,” Pane says. Small companies perform better in the first year of a bull market, she says, because they “can respond faster to the change in the economic environment.” But larger companies “tend to gather speed and take off in the second year.” The decline in the U.S. dollar also bodes well for large companies, she says, because they’re more likely to have overseas operations. “This makes [large companies'] products cheaper overseas, and it also benefits them when they translate that foreign currency back to the dollar.”

James Lowell, chief investment strategist for Adviser Investment Management in Watertown, Massachusetts, and editor of Fidelity Investor, says that the majority of fund managers at Fidelity, Vanguard, and other fund families hewed to their index in 2003. “That goes a long way in saying that advisors have their work cut out for them in what they’re trying to do for their clients: deliver reasonable outperformance with reasonable risk,” Lowell says.

But it was the managers who didn’t stick to their indexes that posted the greatest performance in 2003. “The hallmark of those managers who outperformed in 2003 was that they were the classic go-anywhere managers, as opposed to being style-specific,” Lowell says. The best performing managers also had a 10-year track record; in other words “they’ve been through two recessions,” he says. For instance, Harry Lang, veteran manager of Fidelity’s Capital Appreciation Fund (FDCAX), was up 51.7% in 2003. Lang has a history of “going anywhere,” Lowell says.

Buy the Manager

Lowell says advisors can make better fund choices for their clients in 2004 if they buy the manager and not the fund. “For advisors investing clients’ money, the managers are the market,” he says, “not their underlying holdings, not how they vote proxies.” Very few advisors, he says, “have the necessary tools to be able to deliver on being able to buy the manager and not the fund. For a fund investor, that’s a crucial oversight.” Advisors really need to study the fund manager’s career, Lowell says, which “requires some significant legwork.”

Sector Leaders and Laggards

How did the sectors perform? While all sectors were down in 2002, all of them posted positive returns in 2003. The sectors “started coming back once there was more confidence that the economy was bouncing back,” Pane says. Telecommunications services, up 3.5%, posted the lowest return. “But right out of the gate in 2004, telecom is doing fairly well,” Lowell says.

Two other notable sectors performed poorly last year: healthcare and natural resources. Major pharmaceuticals “trailed the S&P by almost a third,” Lowell says. Such poor performance “has had a dramatic impact on most advisors’ portfolios because healthcare is a significant weighting in the majority of large-cap growth funds that advisors are using,” he says. “In this last bear market, [healthcare funds] lost more than the S&P 500. And climbing out of that recession, they’ve delivered less.” But Lowell likes the healthcare sector in 2004. “We’re moving into healthcare, specifically into major pharmaceuticals, precisely because in 10 years we haven’t seen such attractive valuation and good pricing.” Natural resources–energy, energy services, and natural gas–were also weak in 2003, but Lowell’s a fan of the sector in 2004.

For a downloadable PDF of the top fund performers by category in 2003 and

2002,

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.