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By Christine Benz | 03-29-2011 01:16 PM

Fund Investors on the Knife Edge

Although fundholders showed a willingness to embrace risk in the first quarter, they also look poised to flee at the first signs of volatility, says Morningstar's Kevin McDevitt. Also get our take on energy funds' strong run, small caps' continued outperformance, and the effect of Japan's crisis on foreign fund investors.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the first quarter of 2011 coming to a close, we thought it would be worthwhile to sit down and talk about some of the performance trends that we've been seeing in mutual funds.

Here to do that with me is, Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thanks so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So, Kevin, what we've seen in the first quarter is small- and mid-cap strongly outperforming large. What's driving that trend?

McDevitt: I think there are a number of factors at work. We've been, as a firm, and certainly myself included, we've been calling for the resurgence of large caps. It hasn't happened, and I think there are a couple of reasons why that's the case.

One is, I think, small caps more than mid caps--and more than large caps, certainly--benefit from the current monetary environment we have with the Fed funds rated at zero, and with QE2 and things like that, you're pumping a lot of liquidity into the system, and small caps tend to benefit from that more than large caps to some extent.

Then you also have the fact that with all this money flowing into the system, you also have more M&A activity potentially coming down the pike. And I think that also tends to benefit small and mid-cap stocks.

All of that said, and as you've pointed out and others have pointed out, investors need to be very cognizant of the fact, though, that small caps relative to large caps are trading at huge premiums by historical standards. So, in terms of going forward, I think you really want to be mindful of where valuations are now for smaller-cap stocks.

Benz: Okay. So, another thing I want talk about, Kevin, is the strong outperformance in energy stocks. They really trumped every other category in our database for the first quarter. People know probably the major factors driving that, but I'm wondering if you can kind of review them for us.

McDevitt: Sure. I think the main thing, as you might imagine, is the spike in oil prices. Given what's happening in the Middle East, you have a huge runup in the price of oil, and the energy stocks naturally are a big beneficiary of that.

You've even seen a spike, to some extent, in the price of natural gas, too, which, as a lot of oil and gas companies have been shifting a bit in terms of their portfolios to natural gas, that also benefits them. Again, natural gas hasn't spiked to the extent we've seen in oil, but there is somewhat of a carryover effect there.

Benz: So, I know that the natural resources and energy-specific funds have done really well as a result of these trends. How about diversified funds? Are you seeing any diversified fund managers betting heavily on these areas, and in turn benefitting from them?

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