Actively managed equity mutual funds finally turned the tables on index funds in the third quarter among the funds most popular with defined contribution plans.
A significant stock market rotation plunged mutual funds tracking the Standard & Poor's 500 Index from the best performing general equity investment objective in the second quarter to the worst in the third quarter, according to fund tracker Lipper Analytical Services Inc., New York.
Pensions & Investments' third-quarter ranking of the funds most used by defined contribution plans reflects the market's sharp switchback.
Every one of the top 10 equity mutual funds for the year ended Sept. 30 is actively managed, with greater variation in market capitalization than in P&I's second-quarter ranking. At June 30, six of the top 10 stock funds tracked the S&P 500.
All of the top 10 equity funds beat the S&P 500's return of 40.5% for the year ended Sept. 30 and the Russell 2000 Index return of 33.2%.
This ranking also reflects a market generally kinder to funds focusing on small-capitalization to midcapitalization stocks and favoring value over growth strategies. While nine of the 10 top performing funds in the year ended June 30 were large-cap funds, the ratio was down seven of 10 in the third quarter. Many funds among the top 10 list this time have fairly wide capitalization ranges. Many can be categorized as classic, actively managed, stock-picking funds.
Of the top 10 stock funds, six have a value orientation, three are growth-value blends and just one is a growth fund, according to the investment category classifications used by Morningstar Inc., Chicago.
Third-quarter performance data from Frank Russell Co., Tacoma, Wash., showed the performance of small-cap and midcap stocks narrowed the gap with larger cap stocks. The top 50 stocks in the S&P 500 returned 45% for the year ended Sept. 30, compared with 38.8% for the next 150 stocks in the index and 34% for the next 300 stocks. By contrast, the second-quarter numbers showed a much larger gap between large-and small-cap stock performance: the top 50 stocks in the S&P 500 returned 41.4% for the one year, the next 150 stocks returned 31.8% and the bottom 300 stocks returned 23.2%.
The value stocks in the Russell 1000 Index returned 42.3% for the year ended Sept. 30, compared with 36.3% for growth stocks. Value and growth stock returns were neck-and-neck for the year ended June 30. The growth-value gap was even greater for smaller-cap stocks. Value stocks in the Russell 2000 had a one-year return of 42.7%, vs. 23.4% for small growth stocks.
"Value strategies have been gradually overtaking growth in the last quarter, nearly doubling growth strategy returns. The number of value stocks in the S&P 500 has been increasing in the last few months, and their performance has been beating growth stocks. But part of the story is that the market caps of the better-performing value stocks in the S&P 500 have been dropping and that's a change," said David Masters, a fund analyst at Micropal Inc., Boston.
The one-year equity fund ranking was led by the Vanguard/PRIMECAP Fund, which returned 55.4%, squashing its nearest rival, the Merrill Lynch Growth/A Fund, with a 47.5% return.
The Vanguard/ PRIMECAP Fund had ranked 21st in the year ended June 30.
The New England Growth/A Fund occupied third place with a 47% return, followed by the Neuberger & Berman Partners' Fund at 46% and the Vanguard Growth & Income Fund with 45.6%.
Micropal's Mr. Masters observed: "Every single one of the equity funds on this list (of one-year returns) have above average returns for their categories. All are in the first and second quartile. It suggests the funds are well-chosen" by plan sponsors.
The $7.8 billion Vanguard/ PRIMECAP Fund had an exceptionally good quarter, which helped raise it to the top position, said Jeff Molitar, principal and director of portfolio review of the Vanguard Group of Investment Cos., Malvern, Pa.
"The return of the Russell 2000 was double that of the S&P 500; the 750 basis point gap was one of the widest in history, I think. The exceptionally strong performance of smaller cap stocks in the third quarter really helped this fund," Mr. Molitar said.
The fund is subadvised by PRIMECAP Management Co., Pasadena, Calif.
Mr. Molitar said the investment strategy looks for growth companies at reasonable prices and "identifies the best companies out there using fundamental research. They are classic bottom-up stock pickers at PRIMECAP. The portfolio overall looks very different from the stock market."
The fund's returns were helped by its 30% allocation to technology stocks, which returned 31%. Technology stocks within the S&P 500, by contrast, returned 20%, said Mr. Molitar. Some of Vanguard/PRIMECAP's better performing technology stocks were Texas Instruments Inc., which returned 60% in the third quarter; Intel Corp., which had a 30% return; and Compaq Computer Corp., which returned more than 88% in the quarter.
Vanguard/PRIMECAP also benefited from a 16% allocation to transportation and automobile stocks, which returned 24%, compared with 13% for the sector within the S&P 500. Federal Express Corp., with a better than 38% return in the quarter, and AMR Corp., with a near 20% return, also boosted the fund's overall returns.
Micropal's Mr. Masters noted the list of top funds for the five years ended Sept. 30 is dominated by funds specializing in small-cap to midcap and technology stocks. All of the top 25 funds on the five-year list are actively managed. Seven funds invest in midcap stocks, two in large-cap and one in small-cap, according to Morningstar's investment classifications. Seven funds have a growth orientation and three have a value bent.
At the top of the five-year equity rankings is the Dreyfus Disciplined Stock Fund, which turned in a 31.8% return, handily beating the S&P 500's 20.8% return and the Russell 2000's 20.7%.
The PBGH Growth Stock Fund dropped to second place from first for the five years with a 30.7% return. Rounding out the top five were: T. Rowe Price Science & Technology Fund with 29.3%; the Franklin Small Cap Growth Fund with 29.2%; Vanguard/PRIMECAP with 27.9% .
All returns for more than one year are annualized.
Like many managers, Bert Mullins, vice president and lead manager of the $1.5 billion Dreyfus Disciplined fund, found technology stocks to be the ticket to success. The five best performing stocks in the fund's portfolio during the third quarter primarily were tech stocks: Compaq, Dell Computer Corp., Cadence Design Systems, EMC Corp. and Noble Drilling Corp.
The fund's strategy blends growth and value considerations about 50%-50% and seeks to "own the best companies we can find," said Mr. Mullins.
A quantitative screen guides the 10 staffers who work on the fund toward undervalued stocks that show improving earnings momentum. The team keeps the fund fully invested and sector and industry neutral to control risk, said Mr. Mullins. The strategy rebalances the portfolio every fortnight to a neutral sector position and has beat the S&P 500 in most of the past 15 years. The fund is well-diversified, with about 180 stocks held and a turnover of about 70% annually.
The fund's success can be attributed to a very senior staff, half of whom have more than 25 years on investment management experience. Mr. Mullins himself began managing money in 1968 and said: "I can remember a bear market. A lot of younger managers can't, and I can't believe the way they want to throw themselves out the window when the market shows some volatility. I can remember that in the early years, I did find it hard to believe that stocks can actually go up. I think this experience helps us to hold firm. We are very adamant that if we stick to the discipline, we will do well consistently, relevant to the benchmarks and to the competition."
Mr. Mullins said the Dreyfus team doesn't make fundamental changes in strategy in response to market volatility like that of the past few weeks, but the team might "fine-tune the process a bit. For example, in response to the crisis in Asia, we might over time begin to minimize our exposure by trimming out companies with a lot of exposure to Asian economies."
The pure value strategy of the Neuberger & Berman Partners Fund has produced consistent performance for the fund's co-managers, Robert I. Gendelman and Michael Kassen. There is about $5 billion managed overall using the strategy, with about $3 billion in the mutual fund itself. The Partners Fund jumped up to fourth position in the one-year returns from 18th the previous quarter, and inched up to 10th in the five-year rankings from No. 11.
The market in the third quarter shifted focus from growth stocks in the S&P 500, like Gillette Corp. and Coca-Cola Co., to value-oriented stocks, said Mr. Gendelman
"This shift helped many value managers. If the S&P 500 was a stock, we wouldn't buy it. Good companies are trading at multiples that are just too high for us -they were trading at 20 times earnings based on earnings growth of 10%. Our portfolio, by contrast, had stocks trading at 15 times earnings, based on growth at a comparable level. We just had superior stock performance relative to the S&P 500 in the quarter," he said.
Mr. Gendelman said the firm's investment strategy applies a consistent value approach, looking for companies trading at discounts to the S&P 500 using a variety of measures and fundamental research. The strategy looks for evidence of positive change in its search for "fallen angels," stocks that have been battered but have good potential for upturn. "We're willing to look at companies that were once growth companies and have changed into value buys," said Mr. Gendelman.
Some of the "fallen angels" that have helped the fund's performance are Home Depot Inc., Wal Mart Stores Inc., Revco DC Inc. and Costco Companies Inc., Mr. Gendelman said.
Representing yet another contrast in the ranks of the best performing equity funds over the five-year period, the $3 billion Franklin Small Cap Growth Fund jumped up to fourth place from below the top 50 on last quarter's list.
Edward Jamieson, the fund's portfolio manager, also relies on very intense, fundamental research from 25 equity analysts to back up his bottom-up stock-picking approach. The fund seeks companies with a competitive advantage that will allow them to sustain faster growth than the rest of the industry in which they compete. The fund's capitalization limit is $1 billion, although a stock it already owns may be held until it hits $2 billion. The growth of a company's market cap is one of the principal reasons Mr. Jamieson sells stock. Portfolio turnover averages 75% annually.
One important screen Mr. Jamieson uses considers barriers to entry in an industry and the competitive advantage of near-monopolies. The owners of offshore oil drilling rigs, for example, have a huge advantage in the market because it is cheaper now to rent a rig than to build one. Oil driller Atwood Oceanics Inc. is one stock Mr. Jamieson owns in this industry.
The hotel industry also has fairly high barriers to entry and Mr. Jamieson owns Prime Hospitality Corp. and CapStar Hotel Co. to exploit this advantage.
Mr. Jamieson also uses the company's proximity to Silicon Valley to his advantage in selecting technology stocks. Franklin Advisers Inc.is located in California's high technology corridor in San Mateo, Calif., and Mr. Jamieson said many important U.S. high-tech companies are located within 30 minutes of his office.
Some of the technology stocks that have been particularly good performers are Altera Corp., Linear Technology Corp., Techelec and Natural Microsystems Corp..
High-yield bond funds continued their domination of the bond rankings.
All of the top 10 bond funds for the year ended Sept. 30 are high-yield funds, led by the Fidelity Spartan High Income Fund's return of 17.6%.
Rounding out the top five were Fidelity Capital & Income Fund with a 17.1% return; AIM High Yield/A Fund, 15.8%; T. Rowe Price High Yield Fund, 15.8%; and Franklin AGE High Income Fund, with 15.7%. All of the top five funds beat the Salomon High Yield Bond Index return of 14.9% and whacked the Salomon Broad Bond Index's 9.7%.
And all of the top 10 bond funds for the five-year period are high-yield funds; six beat the 11.6% return of the Salomon High Yield Index for the period. Thirty-six funds of the top 50 beat or matched the Salomon Broad Bond Index return of 7% for the period.
The Fidelity Spartan High Income Fund was first in the five-year ranking with a 14.4% return. It followed by the Fidelity Capital & Income Fund with a 12.6% return; the Dean Witter High Yield/D Fund, with 12.3%; the AIM High Yield/A Fund, with 11.9%; and the Kemper High Yield/A Fund with 11.8%.
P&I annually ranks the 100 equity and 100 bond mutual funds most used by defined contribution plans.
The most recent ranking was published March 17. The top 50 best-performing equity and bond funds, ranked quarterly, are pulled from that universe.