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Market's Downtrodden Made Their Move


For all those stock funds that were beaten down and overlooked in recent years, it was payback time.

In the second quarter, the laggards of the '90s bull market wrested market leadership away from large U.S. growth stock funds, avenging years of frustration--even if only for a while.

"It was a complete reversal of fortune," says Russel Kinnel, head of equities for the publication Morningstar Mutual Funds in Chicago. "All of a sudden you have all these emerging-markets funds, value funds and small-cap funds doing well after being the worst of the lot."

It just goes to show that eventually "everything reverts back to the mean," says Ron Roge, a financial planner in Bohemia, N.Y.

Well, not everything. At least not yet.

Most active fund managers, who themselves have been beaten up over the years for underperforming passively managed index funds, came up short--yet again.

True, the overall statistics say 69% of actively managed U.S. general equity funds did manage to beat the Standard & Poor's 500 index of blue-chip stocks in the quarter, according to research firm Lipper Inc.

There hasn't been a full year in which active managers, on average, beat that index since 1993.

But compared with the more specific category benchmarks, most actively managed U.S. stock funds disappointed again.

For example, Morningstar says only 42% of actively managed funds that invest in large stocks beat the Wilshire 5,000 index of domestic stocks, a benchmark that many pros now believe is a truer standard for large-cap managers than the S&P.

Only 36% of actively managed small-company stock funds beat the S&P 600 small-stock index. And only 19% of actively managed funds that invest in medium-sized companies outperformed the S&P 400 mid-cap index.

The majority of active managers are lagging many of the indexes year to date as well.

"The good news is that most of them [active managers] made money, and most beat the S&P 500, which will take a lot of the heat off them," says John Rekenthaler, Morningstar's director of research.

"The bad news is, if you look more closely, they still had trouble with their true benchmark and competing against index funds that track them."

It's not surprising that so many active managers have beat the S&P 500. That index underperformed the other major indexes last quarter. (See bottom of "Stock Fund Performance" table on this page.)

"Up until now, the S&P 500 has been a difficult benchmark to beat" because the largest companies had for a couple of years been leading the market. That "made active managers look bad," Rekenthaler says. "Now it's an easy benchmark, so it makes active managers look better."

It's also not all that surprising that more active managers didn't beat their appropriate benchmarks for the quarter as well as for the first half of the year, analysts say.

"Indexes look good in strong markets," says Rekenthaler, noting that active managers tend to have a better shot at outperformance when the market is flat or falling, when stock-picking skills matter more.

Indeed, the relatively strong performance of index funds compared with actively managed ones is indicative of how good a quarter and a year this has been so far for equities.

Of the 28 stock fund categories Morningstar tracks, 25 are up year to date, led by Pacific/Asia funds that exclude Japan. These funds soared 38.8% for the first half of the year.

For the three months ended June 30, all 28 stock fund categories tracked by Morningstar saw gains, many of them huge.

Even S&P 500 index funds, which ranked dead last among all general equity funds for the quarter, according to Lipper, gained about 7% over the last three months. And year to date, they're up 12%, which means the U.S. market is on track for a record fifth consecutive year of 20%-plus gains.

Among the big winners so far this year:

* Value funds of all kinds. "Value investing of all forms came back," says Greg Schultz, principal with Asset Allocation Advisors in Walnut Creek, Calif.

What was the spark? Recent news of improving economic conditions overseas, particularly in Asia, and rising interest rates here at home played a big part in jump-starting the rally, analysts say.

During times of rising economic activity, investors are no longer willing to pay high premiums for big, established growth stocks, since earnings growth is readily available in most sectors, notes Morningstar's Kinnel. Instead, investors are more willing to make bets on out-of-favor sectors. And they tend to refocus their attention on stock fundamentals and valuations.

Which may explain why large value funds, which invest in large-cap stocks with relatively low price-to-earnings ratios, came back into favor in recent months.

For the second quarter, the average large value fund saw gains of 9.4%--more than double the quarterly performance of large-growth stock funds. For the year to date, however, large value funds are trailing large-growth funds.

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