The stock market began the year on an optimistic note, and domestic equity funds sang along in harmony.

The average domestic stock fund rose 6.7% in the first quarter, with those in the small-cap sector outpacing mid- and large-cap funds. Small-cap growth portfolios gained 12.2% on average, making it the best-performing style category for the quarter. Small-cap value and blend styles climbed 11.0% and 11.3%, respectively.

All domestic style categories rose in the quarter, with the large-cap sector faring the worst and mid-caps falling in between.

The S&P 500 Index gained 3.7% in the first quarter (excluding dividends), already outpacing the 3.0% gain the benchmark recorded for all of 2005. (Including reinvested dividends, the S&P 500 gained 4.2% for the first quarter of 2006, versus a 4.9% showing for all of last year).

In terms of sectors, industrial stocks have done well in all categories. In addition, large-cap equities have benefitted from the telecom and energy sectors, while materials and consumer staples worked in small-caps’ favor.

Sam Stovall, chief investment strategist at Standard & Poor’s, concedes that the “fat lady may be starting to sing” for small-cap stocks. Earnings growth has been declining — Standard & Poor’s lowered its 2006 operating estimates for the small-cap sector to 16% from 19%, while holding estimates for large-caps steady at 11%. Consequently, small-cap stocks are getting pricey, with an average P/E ratio of 18.4 (versus 15.3 for large-caps) based on 2006 estimated earnings.

While small-cap growth funds have excelled, it should be noted that these vehicles can often be volatile, concentrated in a few sectors, and feature high risk. For example, one of the top-performing small-cap growth portfolios for the quarter, the Kopp Emerging Growth Fund/A (KOPPX), which soared 19.8%, holds 53.3% and 42.1% in the information technology and health care sectors. Given the high risk associated with such holdings and their degree of concentration in the fund, the portfolio carries a standard deviation of 29.08 — versus peer average of 15.76 — and is ranked only 1 Star by Standard & Poor’s.

More diversified small-cap growth small-cap growth funds, with below-average volatility and expenses (and lower returns for the quarter) include Vanguard Small Cap Growth Index/Inv (VISGX) and USAA Mutual Fund:Capital Growth Fund (USCGX). Both funds are ranked 4 Stars by Standard & Poor’s and include large holdings in consumer discretionary, industrial, and energy stocks, and other sectors, as well as information technology and healthcare.

Meanwhile, large-cap stocks, particularly growth-oriented issues, have yet to begin their long-anticipated ascension. The average large-cap growth fund rose only 3.5% in the first quarter, making it the worst performer by style category. Large-cap value and blend funds gained 4.6% and 4.6% on average, respectively. Stovall chalks it up to the 2001 market meltdown, with burned investors hesitant to walk back into the flames. In addition, there’s the Wall Street adage: “Let your winners ride, and cut the losers short.”

With the S&P 500 Index having already achieved nearly half of its expected 9% gain for the full year, according to Standard & Poor’s estimates, the remaining months are not likely to proceed in a straight line, Stovall said.

Stovall believes that should there be a correction in prices this year, “it may occur during the typically sensitive third quarter, yet merely be a pause.” Overall, the U.S. domestic stock market has some positive tailwinds behind it, including healthy economic growth, benign core inflation trends, a mid-year end to the Federal Reserve’s rate-tightening policy and contained oil prices.

Fund Investment Style

First-Quarter 2006 Average Returns (%)*

Large-Cap Growth

+3.5

Large-Cap Value

+4.6

Large-Cap Blend

+4.6

Mid-Cap Growth

+8.4

Mid-Cap Value

+7.1

Mid-Cap Blend

+7.5

Small-Cap Growth

+12.2

Small-Cap Value

+11.0

Small-Cap Blend

+11.3

All-Cap Growth

+6.1

All-Cap Value

+6.3

Domestic Equity Funds (excluding sector and balanced funds)

+6.7

S&P 500-Stock Index

+4.2

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