TOP MUTUAL FUNDS: Carnival for stock pickers

A post-election stock market rally helped winning equity managers top up their returns in Pensions & Investments' latest quarterly survey of mutual funds most used in defined contribution plans.

But with valuations stretched, equity and fixed-income managers alike said it will be tough to deliver in 2005 even half of their 2004 gains.

The Standard & Poor's 500 index jumped 9.2% in the past quarter, lifting the full-year gain to 10.9%. The top 50 equity mutual funds all outperformed the index, with one-year returns ranging from 11.2% to 25.7% for the year ended Dec. 31.

No single niche dominated the latest winner's circle, with value and growth, concentrated and diversified, small-, midcap and large-cap funds all rubbing elbows. While value funds logged the top three equity gains, the latest survey found Janus Capital Group and Putnam Investments — prominent growth shops that stumbled when the great bull market of the late 1990s imploded — each fielding a top-10 equity manager.

"It's been a classic stock pickers' market," said Preston Athey, whose T. Rowe Price Small Cap Value fund posted the top equity 12-month return — 25.7% — for the second quarter running.

(Mr. Athey's fund also took top honors for the five-year period ended Dec. 31, with a compound annual return of 19.7% return. Second was the Fidelity Low Priced Stock fund, 19.4%, followed by the Lord Abbett Mid Cap Value fund, 18.3%; the Neuberger Berman Genesis fund, 17.7%; and the Ariel Fund, 16.8%.)

But the pickings, said Mr. Athey, have grown slim, perhaps especially in his segment of the market. If small-cap equity has grown to a sizable chunk of your portfolio, this might be the time to shift some money to sectors offering better value, including large-cap and midcap growth stocks, Mr. Athey said.

Mr. Athey said some of his energy and commodity-oriented holdings, including metals and mining stocks, helped power his fund's survey-topping results.

But the latest gains have only stretched valuations further in traditional stomping grounds such as real estate investment trusts, banks and industrials, he said.

The tech sector — an unlikely pond for small-cap value investors to be fishing in — remains an exception, as the ranks of institutional investors shunning tech have swelled. Mr. Athey said he's now picking up half a dozen tech stocks — with "fortress balance sheets and high market shares in their specific areas" — to add to his 284-strong portfolio. He declined to identify them.

Returns this year should be sharply lower than last year, but a pickup in merger and acquisition activity could slow the decline, Mr. Athey said.

Recent news that AlphaSmart Inc., a Los Gatos, Calif.-based company in which Mr. Athey has a small position, would be acquired boosted its share price by almost 25% overnight. "It wouldn't surprise me if 5% of my holdings are bought out this year," enough to help performance even if the market slows down, he said.

In second place for the year, with a 25.3% return, was another small-cap value fund, the Franklin Balance Sheet Investment fund. Third was the Lord Abbett Mid Cap Value fund, with a gain of 24.1%.

Howard E. Hansen, the portfolio manager with Lord Abbett & Co. LLC, Jersey City, N.J, who manages the fund together with Edward Von Der Linde, said the latest gain was more enjoyable than the previous year's almost identical 24.9% advance.

In 2003, the fund's focus on stocks trading at a discount — but with potential catalysts that could drive their share prices higher — left it trailing a market where the biggest gainers were beaten-down tech stocks with little in the way of earnings or profits.

Not so for 2004. "Where our portfolio was is what was working last year," said Mr. Hansen. A "significant overweight in basic materials and industrials," and underweighting financial stocks paid off, helping the Mid Cap Value fund outperform its midcap value peers. Even after a solid year, those sectors continue to offer some of the better value in the market, he said.

In fourth place, the Janus Twenty fund — a large-cap growth fund with more than $10 billion in assets and just 23 holdings — racked up a 23.9% gain.

Portfolio manager Scott W. Schoelzel of Denver-based Janus doesn't see himself as leading the growth equity charge after years of advantage for value players: Whether it's eBay Inc. or AutoZone Inc., Bank of America Corp. or Celgene Corp., "I never bought a stock that I didn't think was a value," he said.

"I feel great about the fund. I like the companies, the balance, the mix," said Mr. Schoelzel. Even so, he said he'll be working to get his fund closer to its historic average of 25 to 40 stocks and "flatten it out" by trimming some of his more concentrated positions.

For example, Mr. Schoelzel reduced his fund's top holding — eBay — to 10% of the portfolio from 18% in the autumn of 2004, even as he remains bullish about eBay's prospects. The move was in line with the enhanced "sell discipline" at the firm following the sharp market downturn between 2000 and 2002.

The Fidelity Low Priced Stock fund delivered the fifth best return — 22.2% for the year, and the Ariel Fund, in sixth place, gained 22%.

"We are having to work harder and harder to find good investment opportunities," said Charles K. Bobrinskoy, vice chairman of Ariel Capital Management LLC, Chicago, who oversees Ariel's investment team.

"Some of our favorite names were purchased last year" in M&A deals, he said, resulting in the fund's cash position increasing to 17.5% from 10% during the last quarter. He said managers won't relax their valuation criteria simply to put money to work.

For now, he said, cyclical stocks have already had a good run, but consumer stocks still offer some value. The fund is keeping an eye on sectors in the regulatory spotlight, such as insurance or pharmaceuticals, to see what opportunities emerge, Mr. Bobrinskoy said.

Other winners include the Fidelity Value fund, in seventh place with a 21.2% gain; the Dodge & Cox Stock fund, in eighth place with a 19.2% advance; and the Hartford HLS Capital Appreciation fund, in the ninth spot at 19.1%.

In 10th place is the Putnam Vista fund, a midcap growth fund that gained 18.9%. Since late 2003, it has been managed by Kevin M. Divney and Paul E. Marrkand. Picks that worked well for Vista in 2004 included Toro Co., whose stock surged 75% in 2004, and Symantec Corp., Mr. Divney said.

On the fixed-income side, high-yield bond funds continued to dominate: The Fidelity Advisor High Income Advantage fund took top honors with a 12-month gain of 14.8%.

Portfolio manager Thomas T. Soviero said 2004 turned out to be another "great year," rewarding his decision not to pull back from higher-yielding, lower-rated bonds, such as CCCs, after 2003's torrid gains.

Even now, his portfolio has twice the benchmark weighting in CCC paper, at roughly 32%, with another 30% in B, 10% in BB or higher, and 15% or so in equity.

But Mr. Soviero said that doesn't necessarily mean he's walking on the wild side. "I am more cautious … It's hard to argue for a lot of capital appreciation this year" with the average high-yield bond surging to 105 cents on the dollar from less than 80 cents at the end of 2002, he said.

But it's still a company-specific game, and backed by the "best research department on the buy-side … I have the opportunity to pick individual bonds that do well," such as El Paso Corp. and Levi Strauss & Co., the portfolio manager said. The paper of both companies continues to be rated CCC, despite tremendous progress by both in reducing their debt, he noted.

Mr. Soviero said the high-yield market is looking at single digit returns for 2005, but said increased M&A activity could provide a boost to returns.

Another Fidelity bond fund — the Fidelity Capital & Income fund — captured second-place honors, with a 12.6% return for the year. Portfolio manager Mark Notkin said his fund has the flexibility to invest across the entire capital structure, with the goal of producing excellent returns throughout the credit cycle.

For the latest period, the 10% of the portfolio invested in stocks provided some of the strongest gains, with underperforming positions roaring back as the year ended, Mr. Notkin said. (While Mr. Notkin has an equity limit of 35% for the fund, he said "that 10% is kind of my comfort zone."

The fund's early bet that oil tankers would be in great demand paid off, with shares of companies such as General Maritime Corp. and OMI Corp. gaining strongly. Shares of distressed companies — including specialty chemical firm Solutia Inc., and U.K. cable companies, Telewest and NTL — all rose strongly, said Mr. Notkin.

With high-yield bonds now offering a scant premium of just 290 basis points over Treasuries, investors aren't being paid to take risk. As a result, Mr. Notkin said he's "been taking risk out of the fund over the last six months."

Still there "are opportunities out there … and I think the fund will have another good year" in 2005, he said. But with the high-yield bond market yielding 7%, "expectations have to be muted." Mr. Notkin said the flexibility his fund has to pick good common stocks should prove an important source of alpha again this year.

In third place, New York Life Investment Management's MainStay High Yield Corporate Bond fund gained 12.5%, followed by the Merrill Lynch Bond High Income fund, with an 11.7% return.

In fifth place, the Loomis Sayles Bond Institutional fund gained 11.3%. Portfolio manager Kathleen C. Gaffney said her fund gained by holding "fallen angels" such as Corning Inc. and Xerox Corp., which continued to fight their way back to investment-grade status in 2004.

But now it's become a "very well-picked-over market," and lofty valuations are a growing concern, with the U.S. Federal Reserve sending clear signals that it's looking to drain liquidity from the market, she said.

Ms. Gaffney said her fund now has about 15% of its portfolio in cash, reflecting a belief that something is likely to come along this year that's going to "shake some of the speculation out of the market." The consensus seems to be that 2005 is going to be another 2004, but "I would think there's got to be increased volatility. Something's got to give," she said.