Just when mutual fund managers thought they might be crawling out of the woods, the big bad bear pounced once again.
The second quarter of 2002 was not quite as bad as the disastrous third quarter of 2001, but it wasn't much better. All of the major equity benchmarks were negative for the quarter ended June 30, and many were in double-digit negative territory: the Standard & Poor's 500 index was down 13.4%; the Russell 3000 was down 13.1%; and the Wilshire 5000 was down 12.6%. In the first quarter, each of those indexes was slightly positive.
The declines were even steeper for growth, with the Russell 3000 Growth index down 18.5% for the quarter, the Russell 2000 Growth index down 15.7% and the Russell 1000 Growth index down 18.6%.
And the bad news doesn't stop there, as value equity benchmarks also took hits. The Russell 3000 Value index was down 8%, the Russell 2000 Value index down 8.5% and the Russell 1000 Value index down 2% in the second quarter. Those indexes were up 4.5%, 9.6%, and 4.1%, respectively, in the first quarter.
"The only thing that stopped it from getting worse was that June only had 30 days in it," said Jeff Tjornehoj, research analyst at Lipper Inc., Denver. In fact, it was the sixth worst quarter for the equity market in the last 25 years, according to Lipper data.
The second quarter setback eroded all the investor confidence and gains that had started to build in the fourth quarter of 2001 and first quarter of 2002, Mr. Tjornehoj said. Things started unraveling in April with the rumblings of more corporate accounting scandals following the Enron Corp. blowup and just got worse as others, such as WorldCom Inc., bubbled to the surface. "It turned ugly pretty fast," Mr. Tjornehoj said. "People are cynical right now, and who can blame them?"
In the Pensions & Investments universe of the 100 largest mutual funds most used in defined contribution plans, just three were in the black for the year ended June 30.
The top-performing equity fund for the 12 months was the Fidelity Low-Priced Stock Fund, managed by Joel Tillinghast. The fund was up 15.2%, outperforming the next closest competitor by 10 percentage points.
Second on the list was the Neuberger Berman Genesis Fund, at 5.2%, managed by Robert D'Alelio, Judith Vale and Kevin O'Brien. The fund's small-cap value orientation certainly helped performance, Mr. O'Brien said, as the management team is fishing in a pond that isn't quite as murky as others are. But beyond that, outperformance has come from paying close attention to the cash flow generation of the companies in which the fund invests, he said. The management team does its own leg work in this area because Wall Street hasn't done an adequate enough job of determining what cash flow generation is, he added. "What we're really trying to get at is working capital.
The management teams looks for stocks that have the potential to perform for the next few years so the fund's performance won't be beholden to the fluctuations of the capital markets. "We don't want to buy a name thinking we're going to have to turn around and sell it," he said. While the fund has a low turnover ratio - about 25% in the last year - Mr. O'Brien said the team has passed on more stocks than normal and instead has made strategic shifts among the names it already holds, investing more in some and less in others, based on evaluations. "We've been shuffling some of the deck chairs around," he said.
Restaurants, particularly moderately priced eateries, and home-improvement retailers are two industries that have done well in this market, Mr. O'Brien said. Among the winners in the portfolio are IHOP Corp., Ruby Tuesday Inc., AFC Enterprises Inc., which owns Church's and Popeye's fried chicken restaurants, Starbucks Corp. and CEC Entertainment Inc., which owns Chuck E. Cheese. In the home improvement area, Michaels Stores Inc., an arts and crafts chain, and Furniture Brands International were big winners.
One of three
The only other equity fund in positive territory was the Fidelity Value Fund, managed by Richard Fentin, which posted a return of 3% for the period. The Capital Research Income Fund of America and the Dodge & Cox Stock Fund ran fourth and fifth, with returns of -0.2% and -0.7%, respectively.
The T. Rowe Price Small Cap Stock Fund, managed by Greg McCrickard, placed sixth with a return of -1.2% for the year. The small-cap blend fund has gotten a performance boost from several areas, including the information technology industry, Mr. McCrickard said. Technology stocks such as Analogic Corp., a medical imaging company, ManTech International Corp., an information technology firm, and CACI International, which specializes in IT integration, have performed well for the portfolio, he said.
Henry Schein, a dental products distributor, and A.O. Smith Corp., a motors and compressors manufacturer, also have been winners, Mr. McCrickard said, adding that the hot summer has been particularly good for A.O. Smith, a manufacturer for the heating, ventilation, and air conditioning market.
The last quarter was no picnic for any type of equity manager, he said, but small-cap value stocks have held up better than anything else. While the portfolio's relative performance has come from the value stocks, Mr. McCrickard said he is starting to dabble in growth stocks. "We're stock picking our way through the rubble."
Capital Research's team-managed American Mutual Fund was seventh on the P&I list, with a return of -1.4% for the year, followed by the Fidelity Contrafund, managed by William Danoff, which returned -3.6%. Rounding out the top 10 equity funds is the Baron Asset Fund, managed by Ronald Baron, and the T. Rowe Price Equity-Income Fund, managed by Brian Rogers, which returned -3.9% and -4.8%, respectively.
Bonds doing better
Skies are much brighter in P&I's universe of the 100 largest fixed-income funds used in defined contribution plans. Nearly 80% of the fixed-income funds tracked by P&I were in the black, led by a trio of funds managed by Pacific Investment Management Co., Newport Beach, Calif.
The top-performing fund was the PIMCO Long-Term U.S. Government Fund, managed by James Keller, with a return of 11.6% for the year ended June 30. It beat its benchmark, the Lehman Long-Term U.S. Treasury index, by 2.5 percentage points. The PIMCO Total Return Fund and the PIMCO Total Return II Fund, both managed by William Gross, were next on the list, with returns of 11% and 9.8%, respectively. These funds bested their benchmark, the Lehman Aggregate index, which returned 8.6% for the same period.
John Loftus, managing director at PIMCO, said a healthy exposure to mortgage-backed securities helped boost the performance of the top performing PIMCO Long-Term U.S. Government Fund. Mortgage-backed securities returned 9% for the one-year period ended June 30, according to the Lehman Mortgage-Backed index. Mr. Loftus said strong security selection and a focus on Fannie Mae securities helped drive performance.
A number of factors contributed to the Total Return Fund's stellar returns. The portfolio was concentrated in intermediate-term durations, which was the place to be, Mr. Loftus said. Exposure to foreign bonds also boosted the fund's performance. Up to 20% of the portfolio can be invested in foreign bonds, so Mr. Gross took advantage of opportunities overseas and invested about 15% in foreign bonds, Mr. Loftus said. Management saw the best opportunities in Europe, particularly Germany, where inflation is near zero, he added. About 4% of the portfolio was in emerging market bonds, which also have performed well over the last 12 months, he said.
The exposure to non-U.S. bonds was the primary difference between the Total Return and Total Return II funds; Total Return II does not allow for foreign bonds or non-investment-grade bonds, while the Total Return Fund does.
PIMCO managers have been reducing exposure to corporate bonds over the last few years and the funds are underweight in that sector, Mr. Loftus said. "We looked at the entire landscape of corporate bonds," then started weeding out the ones that looked like trouble two to three years ago. The early identification of potential problems and risk in the corporate sector has helped both funds sidestep the major landmines, he explained.
The management team saw rapid changes in technology having an impact on the long-term viability of some companies. "It's harder and harder to find companies thriving for the long-term, with the rapid rate of obsolescence driven by advances in technology," he said. "It's difficult to be a survivor with such a pace of technological change."
Fourth on the list is the Vanguard Long-Term Corporate Bond Fund, managed by Earl McEvoy, which returned 9.6%; and fifth is the One Group Bond Fund, managed by Doug Swanson, which returned 9.4%.
Overweighting mortgage-backed securities and having strong security selection within the mortgage-backed universe helped drive the performance of the One Group Bond Fund, Mr. Swanson said. About 55% of the portfolio is invested in mortgage-backed securities.
Conversely, the portfolio is underweighted in the corporate bond area, where there has been a lot of volatility and uncertainty, he said. Just 16% of the portfolio is in the corporate sector. Overall, the portfolio thrives on its diversity, Mr. Swanson said.