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The Year in Funds: Mid-Caps Romp

After a choppy start, equities make solid gains in 2005.

John Coumarianos, 01/03/2006

<P><?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SUBHEAD></MSTR:SUBHEAD><EM>Get mutual fund and stock information from our analyst team delivered to your e-mailbox every Tuesday. </EM><A href="http://advisor.morningstar.com/products/enews.asp" ><EM>Sign up for our free Investment Insights e-newsletter</EM></A><EM>.</EM></P> <P>Much like in 2004, a choppy start ended in solid, if unspectacular, gains for equities in 2005. Every domestic-equity category finished in the black, except bear-market funds. Mid-cap and international categories were particularly hot, while growth funds showed signs of life. Bonds struggled, but also eked out gains. All fixed-income categories except world bond squeezed out advances. Emerging-markets bond funds continued their torrid, multiyear run. International equity categories also performed well.</P> <P><STRONG>Equity Funds</STRONG></P> <P>Natural-resources, utilities, and real estate funds led the way again, posting large gains for both the year and the final quarter. Morningstar Analysts Sonya Morris, who covers specialty-natural resources; David Kathman, specialty-utilities; and Dan McNeela, specialty-real estate, all warn against entering hot sectors.</P> <P>Morris notes that energy investors suffered a rude awakening in the fall, as oil prices softened in October after a peak after Hurricane Katrina. Accordingly, we have preferred the PIMCO Commodity Real Return Fund <MSTR:SECURITY>PCRDX</MSTR:SECURITY> for its diversification across a broad swath of commodities, though we have  suspended our recommendation until we learn more about the implications of an IRS ruling regarding the purchases of the commodity-linked swaps that the fund employs.</P> <P>McNeela ultimately sees limited upside to real estate, after weighing arguments that real estate is "priced at historic highs on many measures, including price to cash flows, yield relative to the 10-year Treasury bond, and earnings relative to the S&P 500" and, alternatively, that REITs are showing some growth, evidence of overbuilding is scant, and private market buyers are supporting prices.<BR> <BR>Specialty-health also performed well, with a biotech rally pushing the category up 9.3% for the year. Analyst Christopher Davis likes the sector for the long term, but he recommends that most investors get their exposure through diversified funds such as large-growth funds.<BR> <BR>Speaking of large growth, the category put up a 6.5% return for the year, including 3.4% in the final quarter when it was the best-performing diversified category. Mid-growth led diversified categories for the year, with a 9.6% return. Mid-blend and mid-value were right behind with 9.1% and 8.3% returns for the year, making 2005 a mid-cap romp. Overall, the trend seemed to favor larger and growthier funds, indicating that the tide may finally be turning away from small caps and more value-oriented fare. <BR> <BR><STRONG>Fixed-Income Funds</STRONG></P> <P>Bonds finally felt some of the Federal Reserve's pressure as they struggled to eke out gains, with the Lehman Brothers Aggregate Index up a modest 2.4% through Dec. 23. Accordingly, the intermediate-bond category was up 1.75% for the year. Nevertheless, a "flat" yield curve (little difference between short-term and long-term yields) bespeaks bonds' continued attractiveness to investors, which is keeping the housing market strong and which will keep Alan Greenspan's successor, Ben Bernanke, busy, as he seeks to curb inflation without halting growth.<BR> <BR>Again, the emerging-markets category was the best in the bond group, posting an 11.8% return for the year. The category's torrid five-year run reflects the improving financial health of the developing world and an increase in the amount of bonds with investment grades. Nevertheless, analyst Arijit Dutta warns that "investors should brace themselves for an eventual downturn in this group," especially as interest rates increase in the U.S. (forcing foreign issuers to raise their rates, too) and as GM <MSTR:SECURITY>GM</MSTR:SECURITY> and Ford <MSTR:SECURITY>F</MSTR:SECURITY>, whose debt was downgraded to junk, provide competition for investors' assets. <BR> <BR>The world-bond category, by contrast, declined 3.2% for the year. Funds in this category buy both U.S. government and government bonds of developed countries. These bonds generally have high credit ratings and lower yields, so they will be more sensitive to rising rates and currency fluctuations than emerging-markets bonds. Rising rates and the strengthening dollar, in fact, hurt these funds, as investors were, in effect, exchanging their dollars for foreign currencies that have recently declined in value relative to the dollar.<BR> <BR>Bank-loan funds, carrying "floating rate" corporate debt from lower-quality companies, continued to benefit from rising rates. The category posted a 4.7% return for the year through Dec. 29. This newer category of funds has proved popular with investors for the protection that it provides against rising interest rates; the "floating rate" character of the loans means that they give greater yield as interest rates rise. Such loans tend to suffer in an economic slowdown, however, both in terms of stagnant or potentially declining yield and because of the financial health of the lower-quality companies, whose success and ability to meet their obligations are dependent on a robust economy. Analyst Scott Berry reminds investors that they are not being compensated for the credit risks they are taking in these instruments (relative to the yields on high-quality bonds) as much as they were a few years ago and that the most seasoned funds in the category have delivered an average of 5% per year for the past decade. <BR> <BR><STRONG>International Funds</STRONG></P> <P>International funds surged for the year, with all fund categories rising and those specializing in Latin America and Japan leading the way. Natural resources and wireless telecom stocks boosted Latin America funds. The resource-rich region is benefiting from high oil prices, and economic development has allowed more people to purchase telephones, with many establishing cell phone service before land-line service. Nevertheless, analyst Bill Rocco notes that the category's 54% annualized three-year return through mid-December 2005 is unsustainable. Moreover, Rocco warns that this is the third most volatile category, next to technology and precious metals. As for Japan, analyst Gregg Wolper says that although many companies are reforming "toward a more profit- and shareholder-oriented system," growth appears anemic at a 1.1% annualized rate. Wolper has no picks in the category.</P> <P>The good news for investors is that there are ample picks in the foreign large-value, foreign large-blend, and foreign large-growth categories, which should form the core of a typical investor's international holdings. These categories posted returns in the 14%-16% range for the year. Although we are pleased to see investors flocking to international funds, we hope they will maintain their exposure and not flee during the next cold spell. Once again, foreign small/mid-growth and foreign small/mid-value outpaced their larger brethren for the year, and we encourage investors who have significant exposure to international small caps to consider building the international component of their portfolios the way they would the domestic component, with large caps as the core positions.</P> <P><EM>John Coumarianos is an analyst with Morningstar.</EM></P>

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