Third Quarter in Funds: Energy Powers Equity Funds

Equity markets held up well in the third quarter, despite rising interest rates, destructive hurricanes, surging commodity prices, and airline bankruptcy filings. Every Morningstar diversified domestic-stock fund category posted gains. Meanwhile, many investment-grade bond categories struggled compared with higher-yield offerings, and international funds posted gains, with Latin America offerings leading the way. 

Unless otherwise noted, the following performance data is for the trailing 13 weeks through Sept. 28.

Equity Funds
Generally, growth did better than value, continuing a recent trend, and small companies did better than large ones, continuing an older trend. Small growth and mid-growth, two of the weaker diversified categories over the past five years, led the way, with 4.1% and 4.3% gains. Small blend was right behind, with a 3.6% gain.

Large growth, one of the poorer-performing categories over the past five years, put on 2.6%, outpacing its large-blend and -value peers for the second straight quarter, and also eking out a victory over mid-value. The energy, communications, and health-care sectors helped the growth-oriented funds. Large value, large blend, and mid-value all posted gains, but brought up the rear of the diversified categories.
 
The real estate category posted a positive gain of 1%, but it was among the worst domestic-equity categories, suggesting that its five-year dominance as the single best equity fund category, with an 18% average annual return through Sept. 28, may be fading. While low bond yields are certainly keeping investors interested in the yield-rich real estate sector, Morningstar fund analyst Dan McNeela  warns that yields have come down while valuations have gone up during the sector's multiyear run.

Natural resources, with its latest surge, is now close to catching real estate for five-year honors, and it also walloped all other equity categories for the quarter with a 21% gain. Oil is notoriously volatile, however. As Morningstar fund analyst Sonya Morris  notes, oil stocks are now the "belle of the ball," but natural-resources funds, which are jam-packed with them, "can come down hard when oil prices falter."

Utilities also continued their multiyear rally, tacking on 7.7% as yield-hungry investors and those anticipating mergers from the repeal of Depression-era legislation governing the industry continued to bid up shares. Communications and health-care funds surged for the quarter, as wireless and biotechnology stocks enjoyed resurgences.

Only the bear-market category posted a loss for the quarter. The 1.2% decline takes it into negative territory for the calendar year (negative 1.1%) and also for the trailing year (negative 13%) through Sept. 28. The funds in this category post gains when the market declines and vice versa by using options and futures strategies, so it's not surprising to see them declining lately. We think timing market movements with these funds is a difficult game for most investors to play.
 
Fixed-Income Funds
Once again, the emerging-markets category was the best one in the bond group, posting a 4.2% return. The category's impressive five-year annualized return of 15.54% through Sept. 28 reflects the improving financial health of the developing world. As fund analyst Arijit Dutta  points out, nearly half of the JP Morgan Emerging Markets Bond Index now sports investment-grade ratings, compared with only 5% a decade ago. Nevertheless, risks abound in this traditionally volatile area, as some countries remain highly indebted and resource-rich countries such as Russia and Brazil could stumble if oil prices decline. Yield-starved investors have also bid up prices, as they have avoided lower-yielding developed-country debt.
 
The quest for yield among investors also helped high-yield corporate bonds tack on 1.60%, despite the significant narrowing of "spreads" (differences in yield between investment-grade and lower-grade bonds). This has prompted observers to wonder whether investors are being well enough compensated in yield for the added credit risk they are taking in high-yield bonds.

Additionally, bank loan funds, carrying "floating rate" corporate debt from lower-quality companies, also enjoyed a strong quarter, with a 1.6% gain. 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.
 
Finally, all investment-grade categories except ultrashort bond, short-term bond, and muni national short posted losses for the quarter, with the long-term government bond category shedding 0.82%. Long-term rates continue to remain low, but prices (which move in the opposite direction of rates) declined enough to produce slight losses in nearly all investment-grade funds for the quarter. We think individual investors seeking the credit safety of high-quality bonds but worried about interest-rate risk should gird themselves for some volatility and not try to make very difficult interest-rate and bond market calls by shifting their assets into and out of different maturities abruptly. Nevertheless, as analyst Paul Herbert  notes, for investors loaded up on longer-term bonds, "an extra measure of caution is in order."
 
International Funds 
All international categories posted gains for the quarter, with Latin America rocketing up 28% largely on the strength of energy and wireless-communications companies. The category also surged 10% last quarter. Nevertheless, the combination of investing in one part of the world and the fact that Latin American economies are not as well diversified as economies in the developed world should give pause to investors who want to use these funds as anything more than specialty players.

With returns around the 10% mark, foreign large-value, -blend, and -growth continued to put up strong returns and trounce their domestic counterparts. Precious metals, diversified emerging markets, and Japan rounded out the list of top-performing categories.

All the purely foreign-equity categories (excluding World Stock) finished with better than 7% gains. World allocation (funds with both domestic and foreign stocks and bonds) brought up the rear with a 3.9% gain. As with domestic stocks, small caps and mid-caps have outperformed large caps for the past five years and into this year. Most studies continue to show that individual investors are underexposed to foreign markets, though this may not be the best time to load up on international small- and mid-cap stocks and emerging-markets offerings. Most investors should approach the foreign parts of their portfolios as they do the domestic parts, picking large-cap core holdings first and rounding them out with supporting players.

Notable Fund News
Changing Fee Structures
Vanguard eliminated the 2% redemption fees for shares held less than one year on five tax-managed funds, effective Sept. 15, 2005. Specifically, investors in Vanguard Tax-Managed Balanced (VTMFX), Tax-Managed Growth and Income , Tax-Managed Capital Appreciation , Tax-Managed Small-Cap (VTSIX), and Tax-Managed International (VTMGX) will now only be subject to a 1% redemption fee for shares held less than five years.

Fidelity dropped the minimum investment size for its U.S. Bond Index Fund . Beginning Sept. 1, 2005, the initial investment was lowered to $10,000, placing it within spitting distance of rival index funds, such as Vanguard's Total Bond Market Index (VBMFX). Vanguard's offering still contains a lower minimum hurdle of just $3,000, although there are additional account-maintenance fees for accounts below $10,000. Finally, five Fidelity Spartan municipal money market funds are also lowering their minimum investments to $25,000 from $100,000. And similarly, three taxable money market funds are raising their minimum investments to $25,000 from $20,000, to carry consistency across funds.

In another move aimed at making Fidelity U.S. Bond Index more competitive, Fidelity contractually capped its expenses at 0.32%. That expense ratio is half the size of the fund's typical no-load intermediate-term bond rival. However, it is only average when compared with similar broad market index funds, which typically charge 0.33%.

Also, Fidelity is launching new "Advantage Shares" for some of its index funds, and renaming the existing shares "Investor Shares." The affected funds so far include: Spartan 500 Index , Spartan Total Market Index , Spartan Extended Market Index , and Spartan International Index . The Advantage shares are a type of preferred share class, similar to Vanguard's admiral Share class, and will offer discounted fees for accounts that meet the $100,000 minimum. Thus, while the Investor shares will continue charging 10 basis points, the new Advantage shares will charge just seven basis points. Further, it's worth pointing out that while Vanguard's Admiral shares are available across most of its fund lineup, Fidelity's move is extremely limited at this point.

AIM Investments is finally lowering 12b-1 fees on several funds. This move brings the firm into line with most of the industry. Previously, four AIM funds charged a 0.30% 12b-1 fee, 54 funds charged 0.35%, and one fund, AIM Global Equity (GTNDX), charged 0.50%. The overall expense ratios for the affected funds will only fall a small amount. Based upon the average 1.46% expense ratio of 71 front-load AIM funds, this is a step in the right direction, but more work needs to be done.

Loomis Sayles added fee break points to current Loomis Sayles Bond (LSBRX) and Loomis Sayles Global Bond (LSGLX). In the previous prospectus, the firm's management fee was a flat 0.60%. Now, shareholders will pay 0.60% on assets up to $3 billion, and 0.50% beyond the $3 billion mark for Loomis Sayles Bond, and 0.60% on assets up to $1 billion, and 0.50% beyond the $1 billion for Loomis Sayles Global Bond. As of May 31, 2005, Loomis Sayles Bond had $3.5 billion in assets and Loomis Sayles Global Bond had $1.2 billion in assets. Still, the fees are no bargain.

SEC Hits Fidelity with a Wells Notice
On July 25, 2005, Fidelity announced that the Securities and Exchange Commission served it with a Wells Notice--a document that warns of potential civil action against a firm by the commission. In an article that was first published by The Wall Street Journal, potential improprieties were exposed at Fidelity in the form of traders possibly accepting gifts from external brokers.

While Fidelity's traders acted in an inappropriate manner and have been appropriately disciplined, the improprieties aren't likely to have affected fundholders much, if at all. It has also not yet been shown that a trade was directed to a favored party in a way that would disadvantage shareholders. Fidelity tracks their trades closely, and it seems reasonable to expect that a bad trade would stick out. Moreover, it is ironic that these events were taking place at the same time the trading desk was actually driving commissions down, a big positive for fundholders.

Management Changes
The third quarter of 2005 experienced  a slew of Fidelity manager changes. Here are a few:

Manager William Eigen has left Fidelity. Even though Eigen did not have an especially long record managing his funds, he drove his largest charge, Fidelity Strategic Income , to a top-quartile return relative to its peers over the past three years. Derek Young and Christopher Sharpe were named as new comanagers to replace Eigen. Young joined Fidelity in 1996 and manages similar strategic income funds in Canada, but he doesn't have a public record running funds in the United States. Sharpe joined Fidelity in 2002 and has comanaged the variable annuity versions of Fidelity's Freedom Fund lineup and the Fidelity Arizona College Savings Plan since April and June 2005, respectively. 

J. Fergus Shiel returned to Fidelity to run Fidelity Advisor Dynamic Capital Appreciation Fund  beginning Sept 30, 2005. He replaced the inconsistent John Porter. Shiel rejoins Fidelity after a two-year stint running his own investment firm. Porter meanwhile has replaced Bettina Doulton as portfolio manager for Fidelity Advisor Growth Opportunities (FAGAX).

Elsewhere, Andrew Burzumato has been replaced by Douglas Simmons as portfolio manager for Fidelity Utilities (FIUIX). Simmons will still run Fidelity Select Environmental (FSELX), which he has managed since 2004.

David Baverez of Fidelity Europe (FIEUX) left the firm to pursue other interests. Baverez successfully managed the fund since January 2003 and completely turned around performance--leading it to top-quartile annual returns for the first time in over 12 years. Replacing Baverez on the European fund will be Frederic Gautier. Although Gautier does not have a U.S.-based track record, he has run several European funds since 1999. In that regard, he has a middling record managing the U.K.-based Fidelity UK Growth fund. However, the more diversified European large-cap fund he manages, Fidelity Advisor World Europe, has performed well.

In other manager changes:
John Angrist, whom Kornitzer Capital Management (advisor to Buffalo Funds) recruited in early 2004 to comanage  Buffalo Micro Cap (BUFOX), has left to start his own hedge fund. Angrist wasn't a senior member of Kornitzer's team, but his departure is a setback for the recently launched Buffalo Micro Cap. Angrist, who formerly worked for a private equity firm in New York, was responsible for several good stock picks, mostly from the Internet-commerce industry--an area previously ignored by Buffalo.

Vanguard International Growth (VWIGX) manager Richard Foulkes will retire on Oct. 31, 2005. He has helmed the fund since September 1981 through subadvisor Schroder Investment Management and is currently responsible for 75% of the portfolio's assets. Over Foulkes' career managing the fund, it has posted strong returns with less volatility than its typical foreign large-blend peer. Following his retirement, Matthew Dobbs and Virginie Maisonneuve will assume Foulkes' responsibilities. Dobbs will be charged with watching the Pacific and emerging stock markets and Maisonneuve will cover European companies.

Fund Openings and Closings
Manager John L. Keeley Jr. is moving into mid-cap territory with the launch of Keeley Mid Cap Value . Keeley hopes to duplicate the good long-term performance of his small-cap fund, Keeley Small Cap Value , by utilizing the same distinctive, contrarian strategy of buying well-managed but overlooked companies undergoing spin-offs, bankruptcies, and other corporate restructurings. We like Keeley's experience and success but are troubled by the fund's initial expense ratio of 2.0%, which is 25% more than its typical mid-cap value category peers.

Daedalus Capital is launching a new growth fund. The Chicken Little Growth Fund will utilize a growth-at-a-reasonable price (GARP) approach by buying and holding undervalued growth stocks for three years or more, avoiding short-term plays like many of its contemporaries.

The well-respected group behind the Matthews Asian Funds series is launching a new fund, Matthews India Fund (MINDX). As its name implies, the fund will invest in stocks, preferred stocks, and convertible securities of companies domiciled in the Indian Subcontinent. Our one beef here is the timing of the rollout, which follows a period of strong performance by Indian stocks.

American Century is launching a Long-Short Equity Fund. Such funds use hedge fund-like strategies, which allow them to buy equities that they think are undervalued and sell short equities that management thinks are overvalued.

PowerShares Capital Management is expanding its ETF lineup with the introduction of the PowerShares Global Water Portfolio and the PowerShares FTSE RAFI US 1000 Portfolio. The Global Water Portfolio will track the Palisades Water Index, which consists of 25 U.S.-traded companies that focus on water provision, treatment, and technologies. We question the necessity of launching an ETF based on an extremely concentrated and minor index--especially after other water-themed funds, such as ATC Aquarion Fund, have been liquidated.

Kevin O'Boyle, the former comanager of the successful Meridian Value (MVALX), is launching his own no-load fund using a similar strategy. The Presidio Fund will utilize an all-cap approach to buy undervalued, out of favor stocks. Up to 25% of the fund may also be in convertibles and fixed-income securities. The expense ratio is expected to be 1.50%, which is on the steep side. As such, we'll be looking for expenses to decline sharply if the fund gathers assets. (Full disclosure: Kevin O'Boyle is the brother of Morningstar fund analyst Kerry O'Boyle. Kerry O'Boyle did not contribute to this report.)

Jennison Health Sciences A (PHLAX) closed to new investors in July. Huge inflows from performance-chasing investors have started to affect the manager's high turnover, small/mid-cap flavored style.

Etc.
Chicago-based ICAP Funds is consolidating its lineup by merging  ICAP Discretionary Equity  and  ICAP Equity . Investors should not be too worried by this merger as it will have little impact on the look of the portfolio. Discretionary Equity, a closed fund, rarely used its flexible-asset allocation mandate and it is essentially a clone of the Equity fund. Its low expenses and experienced management team led by Rob Lyon make the fund a good choice in the large-value category. However, we would recommend that investors take a longer look at the more concentrated  ICAP Select Equity --we believe that Lyon is one of the few managers who can skillfully run a smaller, less-diversified portfolio.

The National Association of Securities Dealers recently fined Morgan Stanley DW, Inc. $1.5 million and ordered the firm to pay another $4.6 million in restitution to more than 3,500 customers who have brokerage accounts with the firm. The NASD found that Morgan Stanley did not establish an adequate system to inform customers when low trading and/or low asset account levels kicked in, thereby incurring excessive fees in their fee-based accounts.