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Mutual fund review: Weighing stocks vs. bonds in 2011

Investors may want to rethink their investment mix as economic optimism grows.

January 09, 2011|By Tom Petruno, Los Angeles Times

Like many small investors, Rodney Punt was wary of the stock market for much of the last two years. But the 64-year-old Santa Monica resident recently decided to shift more of his nest egg into equities while reducing what he held in bonds. "The U.S. is coming out of panic mode," he said. "We have an economy that is beginning to pick up."

As 2011 begins, millions of individual investors may be facing the same basic question about their portfolios: Is it time to change the mix?

The market crash of 2008 cast a long shadow, encouraging many Americans to play it very conservative with their money in 2009 and 2010. That meant favoring bonds or cash accounts as ways to preserve capital. Yet that strategy may not work so well in 2011 if the economy accelerates — or even if growth stays slow but inflation rises.

In the fourth quarter, stocks rallied sharply amid growing optimism about the economic recovery, lifting the average U.S. equity mutual fund 10.2% and boosting the return for the year to 16.2%. But that same optimism about growth fueled a rebound in longer-term interest rates that eroded the value of outstanding fixed-rate bonds.

The result: Many bond mutual funds were in the red for the three months ended Dec. 31 as their share prices declined, more than offsetting interest earned in the period — though for some of the most popular and well-diversified funds the net losses came to less than 2%.

For all of 2010, bond and stock funds alike generated positive returns for a second straight year as financial markets continued to bounce back from the devastation of the 2008 crash.

The issue facing markets now is whether the U.S. economy can reach so-called escape velocity, meaning a level of growth that can sustain itself while allowing the federal government and the Federal Reserve to pull back on the trillions of dollars in aid they've provided since 2008.

By some measures the economy is showing impressive momentum. In December, U.S. manufacturing activity expanded at the fastest pace since May, and the service sector grew at the fastest rate in more than four years.

Consumer spending during the holidays finished weaker than it began, but retailers overall still rang up their best season since 2006.

Yet the missing link remains decent job growth. The government on Friday said the economy created a net 103,000 new nonfarm jobs in December, well below the 150,000 that Wall Street had been hoping for.

That raises the risk that the recovery could fade again soon, as it did last spring and summer. The U.S. needs a significant acceleration in hiring to offset other drags on growth: Millions of families remain burdened by debt, the finances of many state and local governments are a shambles, and home prices have begun to decline again in recent months.

Still, some financial advisors say investors should at least consider whether their portfolios are adequately positioned if 2011 looks a lot like the fourth quarter of 2010: an expanding economy that keeps corporate earnings rising but also keeps upward pressure on longer-term interest rates.

"My fear for quite a while has been that people would suffer from being overweight in bonds," said Dan Wiener, chief executive of Adviser Investments of Newton, Mass., which manages $1.3 billion for clients. "You have to adapt to a new reality."

Nobody would advise conservative investors to suddenly abandon bonds in favor of stocks. Bonds obviously are a crucial element of any diversified portfolio for the income they provide and for their relatively low volatility compared with the swings that can bedevil stocks.

The issue now is simply about the mix: Investors who have tilted their portfolios heavily toward bonds in the last two years, and away from stocks, should consider whether their asset mix will provide enough growth if the economic backdrop favors equities over bonds in 2011.

In 2010 the stock market's gains were broad-based, as they were in 2009:

• Mutual funds that focus on large-capitalization, blue-chip stocks were up between 13.5% and 15.5% last year on average, according to Morningstar Inc.

•Small- and mid-size-company shares again outperformed bigger stocks. Typically, strength in smaller stocks is a sign of investors' belief that the domestic economy will continue to expand, because those firms often don't have the global reach of bigger companies.

Small-cap growth funds, which own stocks of companies whose earnings are expected to grow faster than average, rose 26.8% last year.

• Foreign stock funds rose 14.1% for the year, on average, lagging behind U.S. gains. Europe's government debt crisis weighed on stock returns there, as did the euro's slide against the dollar.

But strong growth in emerging-market economies propelled shares in many of those markets. Emerging-market stock funds rallied 19.0% for the year.

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