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May 26, 1997 01:00 AM

SPECIAL REPORT: MUTUAL FUNDS: INDEXING

Christine Williamson
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    Active mutual fund managers had trouble holding their own against a battalion charge of index funds in the latest Pensions & Investments ranking of the domestic equity mutual funds most used by defined contribution plan investors.

    Although the top three spots were held by actively managed equity funds, index funds dominated most of remaining top 10 best-performing equity funds for the year ended March 31. It's a stark contrast to the one-year period ended Dec. 31, 1996, when the top 10 equity funds were entirely actively managed funds.

    Market watchers like Paul Greenwood, senior research analyst at Frank Russell Trust Co., Tacoma, Wash., said when large-capitalization stocks dominate, "index funds just do very well. Active managers tend to emphasize midcap stocks, and they tend to trail when the market shows such a strong preference for large-cap stocks."

    Nine of the top 10 funds are officially classified as large-cap funds, with seven using a blended value-growth approach. Two growth funds and one value fund were also on the list.

    P&I's quarterly mutual fund survey ranks the top 50 best equity and 50 fixed-income performers from the universe of the 100 equity and bond funds with the most defined contribution plan assets under management.

    Performance information was provided by Morningstar Inc., Chicago.

    The Merrill Lynch Growth/A Fund remained in the No. 1 position for the year with 25.9% - a repeat of its one-year return as of Dec. 31. The midcap growth fund was also No. 1 for the five years with 21.9% and No. 1 in the risk-adjusted five-year ranking with 22.1%. All returns of more than one year are annualized.

    The Vanguard Windsor Fund, a large-cap value fund with a midcap tilt, was second for the year with 23.2%. The Dreyfus Appreciation Fund, a large-cap growth fund, was third with 22.9%.

    Within the rest of the top 10 one-year performers, only the Vanguard/PRIMECAP Fund Inc. is actively managed, with a large to midcap bias and a blended value-growth approach. The fund was fifth for the year with 19.9%.

    The remaining six funds are all equity funds based on the Standard & Poor's 500 Stock Index, which returned 23% for the year. Returns for the mutual funds varied from 19.9% for the fourth-place T. Rowe Price Equity Index Fund Inc. to 19.4% for the No. 10 SSgA S&P 500 Fund, managed by State Street Global Advisors, Boston.

    Gone from the top 10 in the one year rankings at Dec. 31 were the actively managed Janus 20 Fund, down to No. 14 from second; the Neuberger & Berman Partners Fund, down to 15 from fourth; and the T. Rowe Price Growth & Income Fund, down to 16 from ninth.

    For the five years ended March 31, all the top equity funds were actively managed. Four of the top 10 funds were large-cap, and five were midcap. Four were value-oriented, and five were growth-oriented.

    The Merrill Lynch Growth/A Fund was No. 1, followed by the PBHG Growth Fund with 21.5%. The T. Rowe Price Science & Technology Fund was No. 3, returning 21.2%; the Putnam New Opportunity Fund with fourth 19.9%; and the fifth-ranking fund was the Vanguard/PRIMECAP Fund with 19.9%.

    Mr. Greenwood of Frank Russell said active managers were hurt over the one-year period because of their bias toward midcap stocks. He said that if the performance of the S&P 500 over the year ended March 31 is broken down, the overperformance of large-cap stocks is marked. The largest 50 stocks in the S&P 500 returned 25.9% for the year, compared with 16.1% for the next 150 largest stocks and 12.9% for the next 300 largest stocks.

    "Since most active managers are severely underweighted in the large stocks in the S&P 500, it was almost impossible for them to keep up with the market as it was in 1996," said Mr. Greenwood.

    Active management appeared to pay off for equity funds most popular with DC plans - all of the top 25 funds were active, and all beat or matched the S&P 500's 16.4% for the for the five-year period.

    Value managers also tended to do better than growth managers, said Mr. Greenwood. The return for the value portion of the Russell 1000 was 17.6%, compared with 14.7% for the growth portion.

    Small-cap growth managers, in particular, were "absolutely crucified in the first quarter this year. They got killed, and the small-cap growth effect was very pronounced. Some small-cap growth managers were down as much as 20% in the first quarter, and this dragged down one-year returns," said Mr. Greenwood.

    By contrast, value stocks in the Russell 2000 Index outperformed the growth stocks by more than 1,000 basis points over the last two quarters.

    But three funds in top 10 best performing equity funds have run somewhat to counter to Mr. Greenwood's general observations to provide defined contribution plan investors with superior long- and short-term performance.

    The $6 billion Merrill Lynch Growth/A Fund is managed by Steve Johns, portfolio manager with Merrill Lynch Funds, Princeton, N.J., who was formerly a pension fund manager. The fund started 10 years ago as the Merrill Lynch Retirement Equity Fund, and Mr. Johns, a former pension fund executive, managed the fund from the outset with his constituency of defined contribution plan, KEOGH and IRA investors firmly in mind. About two-thirds of fund assets are from tax-deferred retirement accounts, and Mr. Johns said he has always managed the fund with horizon of at least three to five years.

    "Now, for instance, we're looking for stocks that will be winners at the turn of the century," Mr. Johns said.

    The fund has a concentrated portfolio of 30 to 40 stocks and turnover that has averaged about 25% per year or less. The low turnover keeps expenses down but requires stocks be durable for the average four-year holding period. Mr. Johns said the approach looks for companies at reasonable prices across all market caps that are run by smart people with a lot of ambition and are at the top of their respective businesses. The fund holds a large position in Schlumberger Ltd., for example, and is building a position in small biotechnology companies that Mr. Johns hopes will bear fruit in the year 2000.

    "We're the opposite of momentum investors. We are not trying to time the market," Mr. Johns said.

    "When price momentum is up, that's when we tend to be selling because its a time we can distribute stocks we bought awhile ago for a low price. When price momentum is declining, we tend to be out there looking for deals."

    The $2.5 billion Dodge & Cox Stock Fund is another fund focused on the defined contribution plan market. The management firm, Dodge & Cox, San Francisco, was a traditional separate account manager that "by an accident of history fell into the mutual fund business at the right time," said Ken Olivier, senior vice president.

    Mr. Olivier said that as defined contribution plans came into prominence, consultants who knew Dodge & Cox for its defined benefit plan management began to ask for a defined contribution investment vehicle. A family of mutual funds was created and has been distributed without much effort by the company.

    "We are focused on the management of the assets and we don't market and we don't advertise. We thought that if we stayed focused and managed the money well, assets would find us - and they did," said Mr. Olivier. The fund's assets are primarily from defined contribution plan investors.

    The Dodge & Cox Fund is making steady strides up the performance ladder, coming into the one-year ranking at No. 24 with 17.9%. For the five years, the stock fund moved to No. 8 with 17.9%. On a risk-adjusted basis, the Dodge & Cox Stock Fund returned 15.4%.

    Mr. Olivier's team manages the fund to be diversified across market caps and sectors, although its investments are generally in stocks with markets caps of more than $1 billion. The fund is classified as a large-cap fund with a value tilt and is very research-oriented.

    The fund probably stands out in terms of performance, said Mr. Olivier, because it is generally fully invested, with less than 10% in cash. "That tends to be a requirement for doing well in a market like we've seen," Mr. Olivier said.

    Turnover in the fund is also very low, about 10% in 1996. "We've had a lot of cash flow and this has enabled us to add to some of our positions without liquidating our holdings, which also helped to get turnover down last year," he said.

    In the last year, the fund benefited from investments in finance stocks and select technology issues. Over the five years, two investment themes helped the fund - general financial stocks, like banks and insurance companies, and cycle-sensitive stocks. The latter, said Mr. Olivier, are companies that are sensitive to changes in the economic cycle. Companies in the capital goods, electronics and computers, transportation and industrial commodity sectors benefited from the economic upturn and the fund remains overweighted in this area, Mr. Olivier said.

    The Vanguard/PRIMECAP Fund is another fund that has probably benefited from its tendency to hold stocks for a long time and to choose across capitalization ranges. It's turnover rate is also just 10%.

    The fund, subadvised by PRIMECAP Management Co., Pasadena, Calif., has been slowing building its portfolio, stock by stock, said Jeff Molitor, a principal and director of portfolio review at Vanguard.

    "It is not an overnight sensation. This fund has been built for the long term and it selects stocks carefully and holds them a long time," said Mr. Molitor.

    The manager looks hard at unit growth, said Mr. Molitor, in stock selection, choosing companies like Intel Corp., which dominates its industry is very profitable and shows significant growth. Intel is the fund's largest holding and is part of the fund's position in aggressive technology companies, said Mr. Molitor.

    Performance is perhaps even more remarkable because, despite an official classification as a large-cap value fund, Mr. Molitor said the fund really holds a lot of midcap stocks. Both Vanguard/PRIMECAP and Vanguard Windsor hold few stocks in the largest 100 in the S&P 500.

    "The portfolios look very different from the market .*.*. and the returns show that. Both of these funds have done well and they haven't had the advantages of owning very much of the S&P 500," Mr. Molitor said.

    The fund's managers aren't afraid to overweight positions in some sectors, such as the 17% weighting in transportation companies, which includes Federal Express Corp. and AMR Corp. The transportation sector is about 3% of the S&P 500, Mr. Molitor said, and the overweighting worked well for the PRIMECAP fund.

    On the bond side, high-yield funds continued their hold on returns. All the top 10 best performing bond funds in the one- and five-year periods ended March 31 were high-yield funds.

    For the one year, the AIM High Yield Fund/A was first with 12.7%; the Franklin/AGE High Income Fund was second with 12.2% and the Federated High Yield Fund was third with 11.6%. The Salomon Broad Bond Index returned 3.62% for the year, and the Salomon High Yield Index was 11.3%.

    Over five years, the Fidelity Spartan High Income Fund was first with 13.4%. Second was the Dean Witter High Yield Securities Inc. Fund with 11.7%. Third was the Fidelity Capital & Income Fund with 11.6%. The five-year return for the Salomon Broad Bond Index was 7.27%, while the Salomon High Yield Index returned 11.4%.

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