MUTUAL FUNDS: Fidelity takes top spots

Bottom-up stock pickers and portfolio managers fishing in hot niche markets were the leaders of the pack for the year ended June 30, according to Pensions & Investment's latest survey of mutual funds most used in defined contribution plans.

Mutual fund rankings here

The top 10 managers of equity funds for the year through June delivered gains that stayed, for the most part, in the 14% to 20% range posted by the winners for the 12 months through March 31. The benchmark Standard & Poor's 500 index rose 6.3% for the period, down slightly from the 6.7% gain for the year through March 31, while the small-cap Russell 2000 index advanced 9.5%, up from 5.4%.

But top-performing fixed-income managers delivered gains of 11% to 22%, or roughly double those posted for the year through March 31, reflecting a spike in long-term U.S. interest rates the year before that pushed bond prices lower. For the latest period, the benchmark Lehman Brothers Aggregate Bond index climbed 6.8%, up sharply from the 1.3% rise for the year through March 31, while the Credit Suisse High Yield index gained 10.1%, up from 7.8%.

On both the equity and the bond sides, Fidelity Investments won the top spot by a wide margin with funds focused on narrow sectors.

On the equity side, the Fidelity Real Estate fund delivered a 34.5% gain for the year through June, beating its nearest rival by nearly 15 percentage points. For the same period, the Dow Jones Wilshire Real Estate Investment Trust index jumped 34.2%.

Portfolio manager Steven J. Buller said his fund's stellar one-year return reflects broader market trends: a big technical correction, partly spurred by the rise in U.S. rates in April and May of 2004, sent REIT valuations tumbling 20% the year before, while prices jumped 12% or so during the latest quarter, he said.

But the fund's survey-topping gain also points up a strategic decision by Mr. Buller and his team of analysts in the past year or so: to focus more on individual stock picking rather than on making relative bets on specific sectors of the market such as shopping malls or office buildings, he said.

With the REIT market growing strongly in recent years, the analyst team has grown to six people, allowing the fund to invest with "more conviction" by taking more concentrated positions, Mr. Buller said. For example, Fidelity Real Estate's top 10 holdings now account for roughly 58% of its total assets, up from the low 40s as recently as 15 months ago, he said.

Looking ahead, Mr. Buller said, he's not losing sleep about the uptick in U.S. interest rates because historically, REIT prices haven't shown much correlation to long-term rate movements. It's impossible to predict year-by-year gains, but investors can probably look for returns of 7% to 10% a year over the midterm, he said.

In second place, the Baron Growth fund, a small-cap offering from New York-based Baron Capital Inc., gained 19.6% for the year.

Ronald Baron, the CEO of Baron Capital and portfolio manager of the fund, said he and his team are too focused on finding the next growth stories among companies with market capitalizations of less than $2.5 billion to worry about tracking benchmarks or broader market moves. "Every minute you spend thinking about what the stock market is going to do is a wasted minute," he said.

The rapid pace of change in the country and the economy creates a lot of opportunities, and the willingness of shell-shocked investors to settle for the middling returns hedge funds are offering up is giving "people like us a tremendous opportunity," Mr. Baron said.

While a recent report by Morningstar Inc., Chicago, expressed concern that more than 50% of the fund's holdings now qualify as midcap stocks, Mr. Baron said that by his definition of midcap — between $2.5 billion and $8 billion — the figure is closer to 25%. Finding a great growth company, only to sell as soon as it crosses an arbitrary tripwire, just leaves too much value on the table, he said.

That difference of opinion didn't prevent Mr. Baron from making Morningstar's stock one of the latest additions to his fund. Baron Growth picked up about 1 million of the 7 million shares the fund research company sold to the public in May for around $20 a share. The share price stands now around $28, and "we're betting they are going to be successful" in meeting the critical needs of U.S. investors, he said.

In third place with an 18.4% return for the year was the Franklin Balance Sheet Investment fund offered by San Mateo, Calif.-based Franklin Templeton Investments.

Portfolio manager Bruce C. Baughman credited his team's success to its single-minded focus on buying good companies of any size trading at "a very cheap price-to-book value" and holding on for the long term. Worrying about benchmarks, he said, is "like trying to swim while carrying rocks."

For the latest quarter, holdings that contributed strongly to the fund's gains included ESCO Technologies Inc., a St. Louis-based maker of filtration and systems testing equipment that the fund picked up in 1993, and Aztar Corp., a Phoenix-based gaming company the portfolio has held since 1995, Mr. Baughman said.

While Mr. Baughman declined to say what he's buying now in anticipation of gains five years hence, he did express concerns about the pace of gains by the homebuilding shares in his portfolio. "I haven't sold any" yet, but it's a situation that has to be watched, he said.

In fourth place, with a 16.5% gain, was the Fidelity Low Priced Stock fund, followed by the Fidelity Value fund, in fifth place, with 16.4%.

For the five years through June 30, the Fidelity Real Estate fund once again beat all comers with a 20.2% compounded annual gain, followed by Fidelity Low Priced Stock fund with 18.7%; the T. Rowe Price Small-Cap Value fund, offered by Baltimore-based T. Rowe Price Group, with 17.7%; the Franklin Balance Sheet fund, up 16.6%; and the T. Rowe Price Midcap Value Fund, with a 16.4% gain.

On the bond side, Fidelity's New Markets Income fund, which invests in emerging market debt, posted a survey-topping 21.7% gain for the year through June, four percentage points higher than its closest rival.

Portfolio manager John H. Carlson said the past year has been a "sweet spot for emerging market debt." A low interest environment and continued strength for commodity exports combined with strong local policy decisions and a lull in the election season overseas resulted in narrowing credit spreads between emerging market debt and U.S. Treasuries that produced capital gains for his fund, Mr. Carlson said.

Mr. Carlson said he and his team of four analysts take a "mosaic approach," tapping a range of sources — including academics, bankers, regulators and multinational companies in the markets the fund invests in— to construct a picture of each country's prospects. That intensive research effort has contributed to New Markets Income's returns, he said.

The overall investment outlook remains positive, but caution is required, Mr. Carlson said. With emerging market debt providing, on average, a 300-basis-point premium over U.S. Treasuries, and with a fuller election schedule overseas and other potential risks looming, this "isn't one of those times that you come on like Tarzan and pound your chest," taking outsized risks, he said.

Mr. Carlson said he remains underweight in investment-grade credits — including Chile, China and Mexico, where valuations are tight — but he has recently overweighted paper from countries favored by "specific catalysts." For example, the strength of copper prices has helped prompt him to pick up more Peruvian paper, and Argentina's success in restructuring its bonds boosted its profile in his portfolio as well.

In second place, with a 17.8% gain, was the Vanguard Long-Term Investment Grade fund.

The Vanguard Long-Term U.S. Treasury fund took the survey's third spot with a 16.2% return. Portfolio manager David R. Glocke said his portfolio's focus on the long end of the Treasury bond market, on the expectation that the yield curve would flatten, paid big dividends over the past year, as pension funds and other investors continued to snap up that paper.

The spread between two-year Treasuries and 30-year Treasuries is now around 57 basis points, down from the average for the past 20 years of 130 basis points, and Mr. Glocke said he expects the U.S. Federal Reserve Board to continue raising short-term rates. At some point, however, players in the "carry trade" — such as hedge funds that have been buying the long end and selling the short end to pocket the spread — will choose to unwind, he said. "Just recently, I've started to take a little bit of the flattening position off of the portfolio, just to hedge my position," he said.

In fourth place, with a 15.6% gain, is the PIMCO Long-term U.S. Government fund, offered by Pacific Investment Management Co., Newport Beach, Calif. Stephen Rodosky, a member of the portfolio management team, said the fund has benefited from closing its short duration. The portfolio's average bond duration had been shorter than that of the benchmark — a good way to position oneself when it looks like interest rates will rise, leaving you with capital losses as bond prices fall. PIMCO officials now believe the Fed will have to worry more about deflationary pressures as early as later this year, so the fund has brought its average duration back in line with the benchmark.

Now the fund is positioning itself for declining volatility, boosting its holdings of mortgage-type bonds and selling put and call options to add alpha, Mr. Rodosky said.

In fifth place, with a 14.4% gain, was the Loomis Sayles Bond fund, offered by Loomis, Sayles & Co., Boston. Portfolio manager Kathleen Gaffney said her multisector fund, which has roughly 40% of its portfolio in non-dollar assets, has stuck to its thesis that the U.S. currency should weaken despite the dollar's rally this year.

Ms. Gaffney said she sees some potential for market volatility, both from an increasingly globalized economy that amplifies the ups and downs of the business cycle and from a potential inversion of the U.S. yield curve, which would squeeze out a lot of the leverage in the market.

Such a squeeze would provide opportunities for her fund by returning some value to the market, she said. Among other recent adjustments, Ms. Gaffney said her fund has added more Asian and emerging market currencies while reducing its holdings of Canadian, Australian and euro-based paper.