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Subprime Crisis Yields Nasty Fund 'Surprises'

Why it's a mistake to fight the last war.

Christine Benz, 09/04/2007

Last week, Gregg Wolper capably argued that despite all of the hand-wringing over the anomalous aspects of the summer subprime sell-off, many of the market's chief behavioral patterns have remained intact. Bonds have outperformed stocks, high-quality bonds have beaten junky ones, and stocks and bonds from developed markets have trumped those from more exotic locales.

Within certain fund asset classes and categories, however, you can identify some performance patterns that could challenge your assumptions about what's safe and what's not. Some of the securities and fund types that fared well in previous market sell-offs have struggled mightily, while other securities and funds you might've filed under the "higher-risk" category have held up pretty well.

Russel Kinnel has already touched on the poor recent performance of ultrashort funds--which heretofore had seemed to be the tamest part of the fund world. What follows is a review of some of the other notable--and nasty--surprises for fund investors over the past month. The bottom line? It's a mistake to extrapolate too much from how investments have fared in previous market downturns, because every down market has different catalysts and affects some securities more than others. If you stay diversified and avoid overheating sectors, however, you'll stand a good chance of faring well in future downturns. That's because in this last correction--as in others--the areas that had recently enjoyed the biggest performance runups have proved the most vulnerable.

Value Has Underperformed Growth
For some investors, particularly those newer to the market, it's an article of faith that growth funds, with their high average price multiples and trend-beholden companies, are riskier than value funds. After all, the typical large-growth fund lost 25 percentage points more, on an annualized basis, than did the average large-value offering during the bear market from 2000 through 2002.

However, growth stocks and funds haven't always gone down more than value, particularly when market participants are worried about economic growth. That was the case recently, as growth funds in every market-cap band outperformed their value counterparts throughout July and most of August.

There are a couple of key reasons for this performance pattern. First, investors have feared that troubles in the housing market could cause a broad economic slowdown, and growth companies are generally more attractive in such an environment. Second, financials stocks, though they've staged a comeback very recently, have been at the epicenter of the subprime crisis, and such names are mainstays for most value funds. (We observed a similar performance pattern amid the Long-Term Capital Management crisis in 1998, with growth stocks outperforming financials and financials-heavy value funds.) That doesn't diminish the case for value stocks and funds, but it does reinforce that they won't star in every down market.

Small- and Mid-Cap Value Have Struggled the Most
In a related vein, the recent travails of small- and mid-cap value stocks and funds may have also been somewhat surprising to some investors. After all, these categories were champs during the last bear market, with funds in this group posting sizable gains even as the broad market struggled from 2000 through 2002. Small- and mid-cap value stocks and funds have gotten crushed during the recent correction, though, for reasons that in hindsight appear pretty logical.

For one thing, some of these funds, such as Hotchkis & Wiley Small Cap Value HWSAX and Schneider Small Cap Value SCMVX, owned some of the housing- and mortgage-related names that are at the heart of the current mortgage crisis. In addition, small- and mid-cap value stocks as a group have appeared vulnerable amid the credit crunch, because small concerns could have trouble securing the financing they need to survive.

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