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As Market Mood Shifts, Mid-Cap Value Funds Shine in Third Quarter

Often overlooked, they topped all categories of diversified stock funds in the period, posting an average total return of 7.8%.


Mid-cap value fund managers who owned few technology stocks in their portfolios the last two years were generally viewed as either clueless or masochists.

John Schneider, manager of the Pimco Renaissance fund, thinks the more appropriate word is "patient."

In a year when tech stocks are getting their comeuppance, that Job-like patience is finally paying off for Schneider and his peers, who had been among the worst-performing diversified-fund managers over the past three years.

Mid-cap value funds--an often-overlooked group of stock funds that focus on undervalued or beaten-down shares of medium-size firms--topped all categories of diversified stock funds in the third quarter ended Sept. 29, posting an average total return of 7.8%, according to Morningstar Inc.

By contrast, the average domestic stock fund rose 2.6% in the quarter, and the blue-chip Standard & Poor's 500 index lost about 1%.

Year to date, mid-cap value funds are up 9.2% on average, while the S&P, the Dow Jones industrial average and the Nasdaq composite index are all down.

"Clearly, last year and the year before that, large stocks outperformed mid-caps and small-caps--and large growth and tech was the place to be," Schneider said. "This year, you're seeing the reverse of that."

Schneider's fund, which has less than 9% of its assets in tech shares, easily sidestepped the spring plunge in the tech sector, then surged 13.2% in the third quarter. It was up 18.4% in the first nine months.

Schneider had plenty of company in the mid-cap value fund universe: While the tech-heavy Nasdaq index tumbled 37% from March 10 to May 23, the average mid-cap value fund rose 8.3% in that period.

For investors who want to diversify away from tech, mid-cap value funds may still have strong allure.

The average mid-cap value fund recently held less than 12% of its assets in tech, according to Morningstar. That is far less than the S&P 500's total tech and telecom weighting of about 35%.

In part, the low tech weighting in funds like Schneider's reflects the makeup of the mid-cap company universe, generally defined as firms with market capitalizations (stock price times number of shares outstanding) of $1 billion to $5 billion.

Mid-cap value managers tend to pick the bulk of their stocks from the S&P 400/Barra index of mid-cap value stocks. Tech makes up just 7.9% of that index.

By comparison, tech makes up nearly 11% of the S&P 500/Barra index of large-cap value stocks and 13% of the S&P 600/Barra index of small-cap value stocks.

What makes a stock a "value" issue? The S&P/Barra value indexes are made up of shares with lower-than-average price-to-book-value ratios. Book value is another term for the net worth of a company's assets.

Many low-price-to-book-value stocks also tend to have lower price-to-earnings ratios. Those are the kinds of stocks that have come back into favor this year as investors have turned more cautious.

Many financial-services stocks meet those qualifications. And that sector has rallied since spring as long-term interest rates have fallen, amid expectations that the Federal Reserve is finished tightening credit.

Hopes for a benign Fed led many mid-cap value fund managers, like Robert Gendelman, who runs Neuberger Berman Regency Trust, to pile back into financial stocks.

"We had actually been underweighted in financials for most of the year," says Gendelman, whosefund was up 14% in the third quarter and 23.6% in the first nine months. "That is until late in the second quarter, when it was my belief that we were closer to the end of the Fed's" rate hikes.

Gendelman began buying stocks such as mutual-fund manager Franklin Resources and insurers such as Ambac Financial Group. Those stocks soared 46% and 34% in the third quarter, respectively.

"Asset managers have done fabulously well, but insurance companies have been far and away the biggest contributors to the fund this year," he said. Rising insurance premiums have helped boost the industry's earnings outlook.

Pimco's Schneider also found success in insurance shares. This spring, Schneider began buying shares of ACE Limited, a property and casualty insurer. When he bought the stock, it was trading at $16, and about six times earnings per share. Since then, ACE has shot to around $37. It's now the top holding in Pimco Renaissance, accounting for 5.3% of assets.

Some Expect Trend to Continue

Many mid-cap funds also benefited from big bets on energy.

Bob Rodriguez, manager of the FPA Capital fund, recently sold his stake in gas driller Ensco International after it soared about 75% this year.

Utility stocks also worked to mid-cap managers' advantage, amid soaring demand for power--and limited supplies--this summer.

But can mid-cap value keep its momentum going? The sector hasn't beaten the S&P 500 consistently since the early-1990s.

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