The mutual funds most popular with defined contribution participants were not immune to the vicious seven-week decline that rocked markets in the third quarter.
Returns of equity mutual funds finally plunged back to earth after multiple quarters of double-digit growth. Only nine equity funds returned more than 10% and only two more than 20% in the 12 months ended Sept. 30, according to data from Pensions & Investments' third-quarter performance ranking of the 50 best-performing equity and 50 best-performing bond funds from among the 100 mutual funds in each asset class most used by defined contribution plans.
By contrast, 95 stock funds topped 10% and 71 beat 20% for the year ended June 30, based on performance data from Morningstar Inc., Chicago.
In fact, the short-term damage was the worst seen in years for these mainly large, core equity funds much used by defined contribution plan investors. Of P&I's list of the 100 equity funds most popular with 401(k) investors, 42 had negative returns for the year ended Sept. 30.
Analysis of third-quarter mutual fund data by Lipper Analytical Services Inc., New York, indicated that about one-fifth of all investment objectives showed their lowest 12-month returns in at least 43 months. Only 11 of the investment objectives tracked by Lipper, nine of which were domestic, showed positive year-to-date returns as of Sept. 30.
"Broadly speaking, 12-month returns in domestic equity funds were the most negative since mid-1994, and for some investment objectives since late 1990," Lipper analysts observed in their third-quarter analysis of equity mutual funds.
While 15 such funds beat the 9.05% one-year return of the Standard & Poor's 500 index as of Sept. 30, it was a poor showing compared with the second quarter, when 25 funds matched or beat the 30.2% one-year return of the index.
Passive managers reasserted their hold within the top echelon of P&I's one-year ranking. Ten of the top 25 equity funds were index funds, starting with the Vanguard Institutional Index Fund Plus Shares at No. 14, which beat the S&P 500 with a 9.13% one-year return, followed by its sister fund, the Vanguard Institutional Index Fund with a 9.1% return. The Dreyfus S&P 500 Index Fund was at the end of the list of index funds of passive managers at No. 23, trailing its benchmark with a total return of 8.47% for the year ended Sept. 30.
Active managers dominated P&I's second-quarter one-year ranking, occupying 23 of the top 25 positions. But most stood faint hope of keeping their lead over passive managers in the third quarter, facing as they did the fourth-worst quarterly correction in the U.S. market in 20 years, according to data from the Frank Russell Trust Co., Tacoma, Wash. Russell's data also highlighted market conditions that were harsh for active managers, which were hurt by their tendency to underweight large-capitalization stocks and utility stocks and their preference for earnings cyclicality.
For U.S. equities the story has remained much the same since early 1994. That market has been dominated by the 50 largest large-cap stocks, said Paul Greenwood, senior research analyst with Russell. The effect is graphically clear when Russell ranks the returns of the Russell 3000 by market capitalization.
On a compound annualized basis, for the five years ended Sept. 30:
* The 50 largest stocks returned 24.3%;
* Nos. 51 to 200 returned 17.2%;
* Nos. 201 to 500 returned 14.1%;
* Nos. 501 to 1,000 returned 12.2%; and
* Nos. 1,001 to 3,000 returned 9.1%.
For the one-year period ended Sept. 30:
* The 50 largest stocks returned 18.9%;
* Nos. 51 to 200 returned -5.6%;
* Nos. 201 to 500 returned -3.2%;
* Nos. 501 to 1,000 returned -13.2%; and
* Nos. 1,001 to 3,000 returned -19%.
"There was enormous bifurcation in the market in the third quarter where the largest stocks were up 19% for the one year and the smallest down 19%," Mr. Greenwood said. "Even the large-cap, active managers don't own the market weightings of the very large stocks and so have performed very poorly over the one-year period."
Last quarter, growth managers did a little better, as did managers who avoided economically sensitive companies, he said.
"There was general concern about the vulnerability of corporate earnings for U.S. companies, which led to investors seeking safety in companies like utilities with consistent earnings power," Mr. Greenwood said.
P&I's third-quarter ranking reflects these market forces among the 25 best-performing stock funds: Every fund focuses on large-cap stocks and all but one is a core equity fund. The exception is the Federated Utility Fund/A, which leapt up to second place for the year ended Sept. 30 with a 20.45% return, up from obscurity in recent quarters. The Federated Utility/A Fund was ranked number 90 for the one year ended June 30 with a 21.57% return.
In fact, the Utility Sector was the best performing broad market sector in the third quarter, with a 2.93% return, according to Callan Associates Inc., San Francisco.
Data from Lipper found that among the investment objectives it tracks, only utility funds had 12-month returns above their 10-year average as of Sept. 30.
Lipper's data also showed that size counted in the volatile third quarter as nine of the 10 largest equity mutual funds held their own, beating the average one-year returns in their investment categories. Of the top 25 equity funds in P&I's one-year ranking, eight are growth funds, only two are value funds and 15 (including S&P 500 index funds) are growth-value blend funds.
The Janus 20 Fund, which returned an amazing 32.52% for the 12 months ended Sept. 30, held the No. 1 spot for the second quarter in a row. It should be noted, however, that even this stellar performer's return in the third quarter was almost 12 percentage points lower than the 47.21% return it clocked in the second quarter this year.
The third-place Vanguard U.S. Growth Fund followed the Federated Utility Fund, with a 16.74% return for the year, up from No. 13 in the ranking of one-year returns as of the end of the second quarter. Second-place Federated Utility was ranked 90 the second quarter. Fourth place for the year was held by the Fidelity Dividend Growth Fund, with a 15.5% return; it held seventh place in the previous quarter. No. 5 was the American Century-Twentieth Century Select Fund with a one-year return of 13.39%, up from No. 21 in the second quarter.
Notable absentees from the top of the one-year charts include the INVESCO Dynamics Fund, which fell to No. 65 with a -2.84% return, from No. 2 in the second quarter. The Vanguard Growth & Income Fund fell to No. 41 with a one-year return of 4.56%, down from No. 8 last quarter. The Morgan Stanley Equity Growth Fund plummeted to No. 55 for the year ended Sept. 30 with a 0.76% return, down from No. 12 for the year ended June 30.
LITTLE LONG-TERM EFFECT
The good news for plan sponsors and their employees is that while dramatic in the short-term, the third quarter's slide had only a modest effect on long-term performance of equity mutual funds.
Lipper's analysts found that from a broad perspective, average compound annual returns for the 1980s and 1990s remain above long-term historical rates, which are about 11%, for virtually all domestic equity objectives. The effect of the third quarter was to bring mutual fund returns closer to historic norms: The 35-year average annual return for Lipper's broadest category -- general equity funds -- was 12.22% as of March 31, was 12.72% as of June 30 and dipped to 12.05% as of Sept. 30.
More narrowly, Lipper found that volatility in the third quarter reduced the long-term, annualized total return for the five years ended June 30 (the difference between 20 quarters and 21 quarters) by 4.4% for capital appreciation funds, by 4.2% for growth funds, by 5.2% for midcap funds, by 6.1% for small-cap funds, by 5.9% for micro-cap funds, by 3.9% for growth & income funds, and by 3.4% for equity income funds. That return for the S&P 500's dropped 3.6%.
The third-quarter effect was even less dramatic over 10 years, Lipper analysts found, with the most severe performance cost of -3.1% for small-cap funds and least severe of -1.5% for equity income funds.
Still, five-year total returns were down significantly in the third quarter. The best performing fund, the Fidelity Dividend Growth Fund, was No. 1 for the second quarter in a row, with a 22.81% five-year return compared with its 34.59% return for the five years ended June 30. The worst performing fund of the 100 largest equity mutual funds with a five-year track record was the American Century-Twentieth Century Vista Fund at No. 94 with a 1.7% return. The same fund occupied last place for the five years ended June 30, but its return was a fairly respectable 10.26%.
There was little change from the second quarter in 25 best performing funds over the five years ended Sept. 30. The proportions of large- vs. smaller-cap funds was 25 and 0; respectively, and active and passive were 18 funds vs. 4.
But style appeared to count for something. Fourteen growth-value blend funds were among the 25 best five-year performers in the third quarter, compared with six in the second quarter. Only four value funds cracked the top 25 for the third quarter, vs. 11 in the second quarter. There were seven growth funds in both quarters' top 25 funds.
Six equity funds beat the 19.9% return of the S&P 500 for the five years ended Sept. 30, compared with 10 funds that beat the S&P's 23.1% five-year return as of June 30.
Returns were much closer among the top five funds for the five years ended Sept. 30. In second place behind the Fidelity Dividend Growth Fund was the Janus Twenty Fund with a 22.34%, up from eighth place last quarter. In third place with a 21.5% return was the Vanguard U.S. Growth Fund, which had been fifth in the second quarter. Down to fourth place from second was the Morgan Stanley Institutional Equity Growth Fund with a 20.71% return. Fifth place was held by the Kemper-Dreman High Return Equity Fund with a 20.34% return, a big jump up from its No. 22 ranking in the second quarter.
High-yield strategies finally lost their persistent dominance over P&I's one-year ranking of the 50 best performers of the 100 bond funds most used by defined contribution plan investors.
In an abrupt change, high-yield funds were absent from the ranking of the top 25 bond funds for the year ended Sept. 30; 11 of the top 25 were high-yield funds in the second quarter. The median return of Callan's High Yield Style classification for the year ended Sept. 30 was just 0.24%, and a -7.43% for the third quarter alone. By contrast, the one-year return of the Salomon Brothers Broad Bond index was 11.47% as of Sept. 30, and 4.15% for the third quarter only.
The best performing bond fund in P&I's one-year ranking was the Norwest Advantage Diverse Bond Fund with a 14.51% return; it had been No. 7 in the second quarter. Second place was held by the Vanguard Long-Term Bond Portfolio with a 14.26% return; this fund had been No. 3 in the second quarter. In third place was the PIMCO Total Return II (Institutional) Fund with 13.1%, up from No. 18 last quarter. Fourth was the STI Classic Investment Grade Bond Fund with 13.02%, up from No. 21 last quarter. Fifth place was occupied by the MasterWorks Bond Index Fund at 12.89%; the fund was twelfth in the second quarter.
Over five years, however, there was little change, and 12 high-yield funds were among the 25 best performing bond funds. In the second quarter, 13 high-yield funds were in the top 25. The median five-year return as of Sept. 30 for Callan's high-yield style was 9.62%, compared with 7.32% for the same period for the Salomon Brothers Broad Bond index.
The same two funds held the Nos. 1 and 2 spots in the third quarter as they did in the second quarter. The Fidelity High-Income Fund held first place with an 11% return and the PIMCO High Yield Institutional Fund returned 10.88%. In third place was the Strong Corporate Bond Fund with a 9.73% return, up from seventh last quarter. In fourth place for the second time was the Federated High-Income Bond Fund at 9.49%. At No. 5 was the Federated High-Yield Fund with 9.11%, which had been 10th last quarter.
