Growth funds score sizzling returns for year

Was the Nasdaq crash of the past few years just a bad dream? Technology aficionados eyeing Pensions & Investments' latest quarterly survey of the top-performing mutual funds most used in defined contribution plans could be forgiven for thinking as much.

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For the 12-month period through Sept. 30, the names of the top-performing funds and their eye-popping gains may stir memories of days before the technology bubble burst in March 2000. The T. Rowe Price Science & Technology Fund led the way among equity funds with a 58.7% return, followed by the INVESCO Technology Fund at 46.5% and the Fidelity Aggressive Growth Fund at 45.4%. Other growth funds in the top 10 include the T. Rowe Price New Horizons Fund and the American Funds New Economy A, boasting 12-month gains of 42.5% and 35.1% respectively.

Many of those funds had been performance leaders three months before, but with returns of only 5% to 8% for the year ended June 30. But with the S&P 500 index rising 24.4% for the year ended Sept. 30, gains have returned to levels last seen during the bull market of the late 1990s.

This time around, though, investors seeking good returns aren't being forced to put all their eggs in one basket. In the latest survey, some value funds and high-yield bond funds also offered 12-month returns ranging from 30% to just less than 50%.

And far from becoming giddy over their recent success, managers in the latest winners' circle describe themselves as cautiously optimistic about the future. Most concede that it will become tougher to continue racking up strong gains, setting the stage for the alpha wheat to be separated from the beta chaff in the next quarter or two.

But after three hard years, those portfolio managers concede they and their growth-oriented brethren finally have a lot to be thankful for. "We've been fortunate" to be in the sector leading the way up as confidence in the U.S. economy has revived, "just as we've been unfortunate for the last three years," said Eric Gerster, a vice president of the T Rowe Price Science & Technology Fund, who assists fund manager Michael F. Sola.

After enjoying a 101% surge in calendar year 1999 as the tech craze peaked, the Science & Technology Fund endured falls of 34%, 41% and 41% in the next three years before hopes for a sustained U.S. economic rebound finally gained traction this year.

The technology rebound this year has favored both quality companies and less solid businesses, fund managers said, and some worry that investors might have become overly optimistic. "Expectations have outrun reality a bit," said William R. Keithler, manager of the INVESCO Technology Fund. "Things have gotten better, but not to the point where they can support valuations where they are," especially for companies whose share prices surged simply because investors are no longer predicting their imminent demise, he said.

"I don't know if this is a bubble, but it's worrisome that there are bubble-like characteristics" to the market's current run, said Rajiv Kaul, who manages the Fidelity Aggressive Growth Fund. The only way to navigate the dangers is to "focus on stock picking," he said. That selectivity has left some of the leading funds trailing their benchmarks for the quarter and year.

For the latest quarter, the T. Rowe Price Science & Technology Fund gained 8.31%, less than the 10.1% advance logged by its benchmark Lipper Science and Technology funds index. For the year, however, the fund was still ahead, 58.7% vs. 56.3%. The INVESCO Technology Fund's 46.5% rise fell well below its benchmark, the Merrill Lynch High 100 Tech index, which rose 84.7% for the year. The Fidelity Aggressive Growth Fund's 45.4% rise bested its benchmark, the Russell Mid Cap Growth Index, which gained 38.9%.

Mr. Gerster said the Science & Technology fund has been content to underperform its benchmark index by avoiding high-flyers. "We have a type of investment we like to make" — in companies with records of consistent growth, strong management, strong balance sheets and an ability to take market share, Mr. Gerster said. Such criteria "lead you away from some of the more speculative investments in technology," he said.

The Science & Technology Fund's chart-topping numbers reflect its willingness to make more aggressive bets on companies that met those criteria, even as the market was dumping them 12 months ago, Mr. Gerster said. The fund did especially well in the software sector, which accounted for just less than 30% of its portfolio as of Sept. 30. Mercury Interactive Corp., a Nasdaq-listed business software company, is one example, he said. The company's stock dropped to about $16 a share a year ago, despite an impressive management team that succeeded in boosting cash flow throughout the downturn. The fund beefed up its holdings of the stock, which closed at $48.76 on Nov. 3, Mr. Gerster said.

Another winner was Nasdaq-listed Veritas Software Corp., a memory storage firm. The stock was sold off in early October 2002, when the Kenneth E. Lonchar, the company's chief financial officer, resigned amid questions about the accuracy of his resume. "We took advantage of what we thought was a disconnect in the value of the company to increase our position," padding the fund's holdings when the stock was selling for less than $12 a share in October 2002, Mr. Gerster said. Veritas shares closed at $37.17 on Nov. 3.

In addition, Microsoft Corp., the fund's largest holding, accounted for 10% of the portfolio as of Sept. 30. But the fund also counted several hardware and semiconductor stocks among its top 10 holdings, including Cisco Systems Inc., Dell Computer Corp. and Analog Devices Inc.

INVESCO's Mr. Keithler agrees that sticking to quality companies is key to maintaining top performance numbers. However, his picks favor sectors such as semiconductor and hard disk drive makers over software companies. In fact, Microsoft is one of the few market leaders that Mr. Keithler said he isn't betting heavily on in his fund, believing the software giant's growth prospects will be less exciting in the future.

Instead he has favored other software companies that are launching new products and boast a large customer base. Mr. Keithler said one winning bet he made over the past year was picking up Adobe Systems Inc., producers of the popular Acrobat software. It was trading in the $20 range when he bought it in January, and has maintained a position of between 1.2% and 1.4% of his portfolio. Today the stock is trading around $45 per share.

Mr. Keithler said semiconductor companies and hard-disk drive companies, two sectors that got slaughtered during the tech wreck, are areas that have contributed to his fund's performance numbers. For the chip makers, while "everyone drank the Kool-Aid during the bubble and believed that growth rates over the long term were higher than they are ... most of these companies have got their costs in line with their (near-term) prospects," and some better-than-expected revenue growth is going straight to their bottom line, he said. Texas Instruments Inc., which has a 1.7% share of the portfolio, has helped performance, and National Semiconductor Corp., which Mr. Keithler believes is strengthening its operations much more than most people give the company credit for, has also contributed.

Hard drive maker Seagate Technologies has been another winner, Mr. Keithler said. Disk drives — a highly competitive commodity product — has been a difficult industry for investors to make money in, but there has been significant consolidation in recent years, he said. The INVESCO Technology Fund participated in Seagate's public offering at the end of 2002 at about $12 per share; today Seagate is trading closer to $30, he said.

Fidelity's Mr. Kaul said he has also benefited from owning semiconductor makers such as Intel Corp., the third-biggest holding in his portfolio, and like Messrs. Gerster and Keithler he counts Veritas among his top holdings as well. After taking over the fund from Robert Bertelson in November 2002, he added Intel to his portfolio in time for that stock's torrid run. Wireless telecom provider Nextel Communications Inc. was another stock that contributed to performance.

But Mr. Kaul also has been attracted to the health-care sector, with a lot of innovation possible in the sector and demographic support from the graying of the baby boom generation. The two top holdings in his portfolio are Genentech Inc. and St. Jude Medical Inc.

Mr. Kaul said his search for companies with the right product cycles and the most sustainable earnings profiles has also led him to diversify his fund holdings. The number of stocks in the Fidelity Aggressive Growth Fund has doubled during his first year as manager to 370 as of the end of September.

T. Rowe Price's Mr. Gerster said there's no strong trend today of investors either jumping in or bailing out of technology funds. But macro-economic trends in the U.S. remain favorable and Japan is showing signs of life, which could provide a significant boost, he said.

For the latest 12-month period, some bond funds were still giving equity funds a run for investors' money in delivering impressive gains.

The high-yield Fidelity Capital & Income Fund crushed the competition, delivering a 47% return for the year through Sept. 30. Its closest competitor was its cousin, the Fidelity New Markets Income Fund, with 41%.

Mark Notkin, who took over the Capital & Income Fund in July after David Glancy left Fidelity, said investors can't expect to continue seeing that sort of return from high-yield bond funds — which reflect the "perfect storm" that hit the market in 2001 and 2002 — again anytime soon.

But Mr. Notkin said against any normal set of expectations, the outlook for the high-yield market in the coming year remains quite attractive. The yield to maturity for the overall market stands at more than 400 basis points above that offered by U.S. Treasuries, or roughly 8.4%, and with Fidelity's record of securities selection, double-digit returns should be possible, he said.

Mr. Notkin said the decision by Mr. Glancy to heavily overweight telecommunications and utilities paper contributed to the fund's outperformance in the latest survey. Holding the bonds of a company such as Nextel, which was painted as a distressed company even though it was doing everything right to get its house in order, helped boost the fund's returns, he said.