Domestic Equity Funds -- Mid-Year 2004 Review

July 1, 2004 — So far this year, value funds have been in the winner’s circle, as negative headlines apparently are driving investors to attractively priced, high-quality stocks.

“Investors don’t like uncertainty,” said Sam Stovall, chief investment strategist of Standard & Poor’s, adding that there has been a rotation toward value investments because of higher interest rates and questions about the strength of the U.S. economic recovery. These uncertainties are fueling gains for value stocks, which generally pay higher dividends, Stovall noted. So far this year, domestic equity fund returns mirror this trend, with value funds leading in each category.

Value funds may be holding up better amid the year’s difficulties, but U.S. stock fund returns suggest investor concerns are having an impact. So far this year, the average domestic equity fund is up 3.99% and the S&P 500-stock index is up 3.29%. Those are positive, but not stellar results for the second year of a bull market. Standard & Poor’s is predicting a year-over-year gain of about 9% for the S&P 500 in 2004. “We’re behind in our bogey” so far this year, Stovall noted. Factors unsettling investors include higher interest rates, oil price hikes, terrorism, and the presidential elections.

The market’s unease also seems to have diminished average returns for domestic equity funds in the second quarter. All U.S. stock fund categories showed modest average gains for the period, save small-cap growth funds, which were down 0.51%. The average domestic equity fund rose 0.91% in the second quarter. The “neutral, range-bound market” for the period stems from investor concerns about inflation, rising interest rates, and geopolitical developments, said Rosanne Pane, Standard & Poor’s mutual fund strategist.

Losses for small-cap growth funds in the second quarter reflect investor apprehension over higher interest rates, Stovall said. Smaller companies may be some of the first to be affected by higher costs of capital, he notes. From a growth fund standpoint, Stovall says a rotation into the large-cap arena is underway.

“We’re finding more opportunities in the larger-cap space,” said Scott Moore, manager of American Century Value/Inv (TWVLX). His fund invests in stocks of all sizes. Moore feels large-cap stocks may be relatively more attractive because of small- and mid-cap outperformance in recent years. Despite that, he is currently finding potential investments across the market-cap spectrum, particularly in industrial stocks. A large-cap value portfolio, American Century Value has risen 6.2% so far this year.

“Investors will probably move more money into larger-cap stocks in the near term,” said Mike Balkin, manager of William Blair Small Cap Growth/A (WBSAX). Although Balkin expects small-cap stocks will still offer opportunities, he believes they won’t outperform large caps “to the same degree as last year.” A small-cap value fund, William Blair Small Cap Growth was up 11.5% so far this year.

Outlook