Defined contribution plan investors were rewarded with phenomenal returns from the equity mutual funds they use the most.
Pension & Investments' performance ranking of funds for the year ended March 31 started with a 57.1% return for the No. 1 stock fund and ended with a 42.9% return for No. 50 -- numbers surely beyond the wildest expectations of most 401(k) plan participants and their employers.
Over the five years ended March 31, equity funds also provided investors with heady returns, ranging between 25.8% for a three-way tie for first place down to 20.4% for No. 50.
Market observers said active stock pickers were at last being rewarded for their patience and commitment, as small-cap and midcap stocks looked better and better relative to large-cap stocks. Dropping the dismal results of the first quarter of 1997 -- one of the worst in history for smaller-cap stocks -- greatly helped the one-year results for active equity managers, said market observers such as Paul Greenwood, a senior research analyst at Frank Russell Co., Tacoma, Wash.
As a result, active fund managers exerted even stronger dominance over passive, large-capitalization managers for the third straight quarter in P&I's performance ranking of mutual funds.
P&I's first-quarter special report ranks the 50 best-performing equity and 50 best-performing bond funds of the 100 mutual funds in each asset class most used by defined contribution plans (P&I, March 23).
In the year ended March 31, all of the top 20 equity funds were actively managed and all exceeded the 48.01% return of the Standard & Poor's 500 stock index for the year ended March 31. A year earlier, six of the 10 top-performing equity funds were passive funds tracking the S&P 500.
Growth management styles made a significant comeback in the one-year rankings. Eleven of the 25 best-performing stock funds were growth-oriented, as judged by their Morningstar Inc. style category. Seven of the top 25 were value funds and seven were growth and value blends. For the year ended March 31, 1997, only one growth fund was among top 25 equity funds. Seventeen value-oriented and seven blend funds were also among the top performers.
The shift in dominance to growth managers in P&I's mutual fund report was supported by the overall strength of growth stocks relative to value stocks. Callan Associates Inc.'s Large Cap-Growth Style median for the year ended March 31 was 50.51%, compared with 39.29% for the Callan Large Cap-Value Style median for the same period.
P&I's first-quarter 1998 performance charts also show that the market has stopped rewarding large-cap managers quite as richly as it has for the past few years.
Eighteen of the 25 best-performing equity funds for the year ended March 31 had large-cap biases, according to the Style Box Morningstar calculates for each fund based on its portfolio holdings. Seven funds had midcap biases. By comparison, for the year ended Dec. 31, large-cap funds took 23 of the top 25 spots; one was a small-cap and one a midcap fund.
The performance of the pack of seven S&P 500 index funds popular with defined contribution plan participants slipped down the performance list to occupy slots from 21 to 27 for the year ended March 31, from ranking 7 and from 10 to 15 for the year ended Dec. 31, 1997.
"The one-year period was a favorable comparison period for smaller-cap managers. It drops off the first quarter of 1997 from managers' returns, which was one of the worst quarters the smaller-cap managers ever had. This time period nicely captures the rebound of smaller-cap managers and it was definitely a friendlier environment for active managers than the last five years were," said Russell's Mr. Greenwood.
But he cautioned that "you need to remember how important the time frame is. If you backed it up one quarter and had a look, essentially at 1997, you'd see one of the worst years in history for small-and midcap products. It's when smaller stocks start to look better than large-cap stocks or the environment is at least benign toward smaller company stocks that active managers begin to look great."
The best-performing fund in P&I's universe for the one-year period was the INVESCO Dynamics Fund, which provided investors with a 57.1% return. In second place was the Putnam Investors Fund with 56.1%, followed by the third place Putnam New Opportunities Fund with 53.9%. Three funds that returned 52.2% over one year tied for fourth place: the American Century-Benham Growth & Income Fund, the Putnam OTC-Emerging Growth Fund and the Putnam Voyager Fund.
Tom Wald and Tim Miller, managers of the $1.3 billion INVESCO Dynamics Fund, attributed their success to a rebound in midcap stock successes over the 12 months ended March 31. The Dynamics Fund is a midcap growth stock fund and its managers said they look for three characteristics in constructing the fund's portfolio: growth markets; leaders in very competitive markets; and financial returns that validate the company's growth rate.
Mr. Miller and Mr. Wald said they also made some moves in the portfolio in the second half of 1997 that significantly enhanced performance, as a more favorable environment for midcap managers commenced. The fund's weighting to the communications sector was drastically increased to 12% of holdings from 3%, primarily because the two men saw dynamic growth potential in the sector, primarily due to deregulation in the U.S. and abroad. Significant opportunities arose for midsized communications companies, which were in turn extremely good acquisition targets. Some of the fund's most successful stock purchases late last year were Intermedia Communications, Brooks Fiber Properties and Colt Telecom Group.
In the health-care arena, Mr. Miller and Mr. Wald moved out of service and biotechnology companies and into device manufacturers, drug and drug delivery companies. The pair made significant gains with "our classic kind of stock, Guidant Corp.," which more than doubled in 12 months, Mr. Miller said, and Watson Pharmaceuticals, which makes generic drugs.
The managers took advantage of a major sell-off of technology stocks in the fourth quarter last year to upgrade to quality technology companies at reasonable prices. The portfolio managers typically invest between 20% and 30% of assets in the technology sector and with some shifting. Mr. Miller and Mr. Wald bought "a lot" of PeopleSoft Inc., which they said rallied. Both technology companies, the managers said, typify what they like to hold in the fund.
The $11 billion MFS Emerging Equities Fund jumped into the one-year ranks at number eight. It hasn't been around lately in previous P&I surveys, primarily because the market has been so focused on large-cap stocks in the S&P 500, said the fund's manager, John Ballen.
The aggressive growth fund's mandate is to invest in "fast-growing companies. We're a real stock picker's fund and finally, a lot of stock pickers are finally beginning to be rewarded for looking outside the index for companies. The market is beginning to reward for the differentials -- the companies with cheap prices and good fundamentals. The market has been rewarding on the basis of what was in the index and people were buying S&P 500 companies whether earnings were good or bad and laughing at valuations. It's changed," Mr. Ballen said.
He has a long holding period for the stocks he buys -- an average of five to six years -- and he looks for companies with average earnings growth of 25%. The fund has shown strength across a broad range of sectors and industries, Mr. Ballen said. More than 100 of the stocks he owned were up over 30% in the first quarter this year alone.
Technology companies, especially software developers, ratcheted up big gains. Some of Mr. Ballen's best holdings were BMC Software, Compuware, Oracle Corp. and Cadence Design Systems. Business services, such as AccuStaff, also rewarded, as did specialty retailers such as Brinker International and Showbiz Pizza Time. In health care, Mr. Ballen said he found good success with HMOs, particularly United Healthcare Corp.
Active managers also prevailed over the five years ended March 31.
Fifteen equity funds beat the S&P 500's 22.39% annualized return for the five years ended March 31. Passively managed funds moved up to the mid-teens in the latest five-year ranking, up from the mid-20s to mid-30s for the period ended Dec. 31, 1997.
Growth managers made slight inroads. Seven of the top 25 equity funds for the five years ended March 31 were growth managers, compared with the five growth managers present in the rank for the five years ended Dec. 31. By comparison in the broader equity market, Callan's Large Cap-Growth Style median return was 20.5% for the five-year period, compared with 21.19% for the Callan Large Cap-Value Style median.
The number of value mangers dropped to 11 of the top 25 stock funds as of March 31 from 16 as of Dec. 31. The ratio of large-cap, midcap and small-cap managers over the five years ended March 31 changed little from P&I's performance ranking as of Dec. 31.
The five best-performing equity funds for the five years ended March 31 were the Franklin Small Cap Growth Fund, the Morgan Stanley Equity Growth Fund and the Putnam New Opportunities Fund, all tied with 25.8% returns. The T. Rowe Price Science & Technology Fund was fourth with 24.9% and the Vanguard PRIMECAP Fund was fifth with 24.8%.
The growth equity management group at Putnam Investments Inc., Boston, was richly represented among the top equity fund performers. The company had five funds among the top 20 for the year ended March 31 and four in the top 20 over five years.
Carol C. McMullen, chief investment officer of the global growth equities group at Putnam, said the funds have stayed true to their growth mandates and have continued to perform in the top half of their peer asset class group over one-, three- and five-year periods. The five popular funds -- New Opportunities, Investor, OTC-Emerging Growth, Voyager and Vista -- follow the same investment themes but have different aggressiveness levels, which are determined by how much is invested in varying market-cap weightings by each fund.
Investor is the most conservative of the group, with an emphasis on large-cap, blue chip stocks. OTC-Emerging Growth has the greatest exposure to small-cap growth stocks and is the most aggressive of the five funds.
Among the strongest investment themes within the growth group is technology, with a focus on networking and communication companies, said Ms. McMullen, who herself manages $19 billion in the New Opportunity Fund and its various clones.
Putnam is looking for companies -- such as those serving the Internet -- that are beneficiaries of large communications spending by other companies, governments and consumers. It also looks for media companies, such as Clear Channel Communications. The funds have always owned Microsoft Corp., which is a good example of the kind of technology companies the funds' investment teams seek, Ms. McMullen said.
The strategy also seeks companies that provide value to consumers through providing or serving low-cost health care delivery systems. Large-cap pharmaceutical companies on the verge of launching new drug products that will realize strong gains have been one focus of the group.
Both Pfizer Inc. and Bristol-Meyers Squibb Co. are owned by the funds, primarily because they are involved in delivering pharmaceuticals inexpensively, Ms. McMullen said. In her own fund, she said, she recently increased the weighting to health care to 36% of holdings from 31%.
Companies in the financial services industries, such as American Express Co., The Travelers Group and MBNA Corp. have also been good holdings within the funds because they have benefited so strongly from consolidation and asset gathering successes.