First Quarter in Funds: Small- and Mid-Caps Lead Again

Equity markets surged in the first quarter, despite continued rising interest rates, fears of a housing bubble bursting, and threats of an economic slowdown. Small caps and mid-caps outperformed large caps, while international stocks outpaced their domestic counterparts. Both of these are familiar patterns. Bonds were weak, as they continued to feel the effects of the Federal Reserve's multiple rate increases for the second straight quarter, though high-yield (junk) and emerging-markets bonds continued their multiyear runs.

Equity Funds
The smaller the market cap, the better the performance for the first quarter of 2006. Among the diversified funds, small caps rallied the hardest, with small-growth, small-blend, and small-value adding 12.7%, 12%, and 10.8%, respectively. Mid-caps were right behind with growth, blend, and value adding 9%, 7.2%, and 6.7%, respectively. Interestingly, growth outperformed value in both market-cap ranges, perhaps signaling a rotation toward growth and away from value. Small-growth and mid-growth have outperformed their value counterparts for the past year now.

Large caps brought up the rear, and in their case, there has been no rotation from value to growth. Large value rose 4.8%, while large-blend added 4.5%, and large-growth tacked on 3.6%. Morningstar analysts have been anticipating a rebound for large growth, but it has yet to materialize. In the meantime, some of our favorite large-value and large-blend funds are also picking up slow-growth names. We've heard many managers remark that large-growth stocks haven't been this cheap in a long time.

In the specialty categories, real estate continued its multiyear run, leading all categories with a 14% gain. Analyst Dan McNeela  warns that real estate is richly priced by many measures, "including price to cash flows, yield relative to the 10-year Treasury bond, and earnings relative to the S&P 500." Although there doesn't seem to be overbuilding, which has traditionally been the cause of the worst downturns in the sector, McNeela signals caution, seeing limited upside in the sector presently.

Telecommunications and natural resources finished the quarter with 10% and 8.4% gains, respectively. The telecom funds that did the best were generally those that had the most hardware and technology exposure. We think this is a tough and volatile category with short product cycles and intense competition. Similarly, natural-resources analyst Sonya Morris  points to energy's downturn in the fall of 2005 in the wake of Hurricane Katrina as a warning to investors about commodity price volatility.

The bear market category brought up the rear with a 4.4% loss. The funds in this category essentially make bets--through options and futures strategies--that the market will fall. These are difficult funds to use, because it's so hard to time market declines. We urge investors to avoid them.

Fixed-Income Funds
Bonds continued to feel pressure from the Federal Reserve's rate-raising campaign. The Lehman Brothers Aggregate Index dropped 0.65% for the quarter. The yield on the 10-year U.S. Treasury Note went from roughly 4.4% to 4.8%. (As yields go up, prices of existing bonds decline, sometimes causing their total return to be negative.) The intermediate-bond category, most of whose members use the Lehman Aggregate Index as their bogy, declined 0.53% for the quarter. With yields creeping up and bonds consequently flirting with negative returns, expense ratios become crucial in determining whether a bond fund can eke out a gain or not.

Interestingly, TIPS (Treasury Inflation-Protected Securities) funds dropped 2.2% for the quarter. These funds typically have longer maturities than intermediate funds, which explains their decline. Although their inflation-protection component would seem to immunize them against rising rates, this is not always the case. The reason for this is that the principal value of these bonds is explicitly tied to the consumer price index (CPI), which is a primary inflation indicator. However, the Federal Reserve may raise rates before indications of inflation appear in the CPI (or even if they don't appear), potentially making these bonds as interest-rate sensitive as other, more ordinary bonds.

High-yield bonds did well, adding 2.6%. The spreads between the yields on lower-quality bonds and high-quality Treasuries has narrowed dramatically in recent years, but yield-hungry investors continue to take on the risk in exchange for the modestly higher yields. At a certain point, investors may become enticed by higher-quality offerings, sending the prices of the low-quality bonds down. Emerging-markets bonds also did well, surging 2.4% and continuing their multiyear run. Emerging-markets analyst Arijit Dutta  reminds us, however, that all multiyear rallies must one day end.

Bank-loan funds also chugged along, gaining 1.9%. Bank-loan funds own "floating rate" instruments issued by companies with below-investment-grade credit quality but that place the investor in a more senior position to the bondholder in the event of distress. The floating-rate feature makes these bonds extremely attractive in rising-rate environments, but rising-rate environments can also portend an economic slowdown, which can be bad news for highly leveraged companies. Analyst Scott Berry  thinks that bank-loan funds hold appeal for investors looking to balance their interest-rate-sensitive holdings.

The municipal-bond group did not have any losing categories, though most categories posted only very modest returns. The muni national intermediate category was flat for the quarter.

International Funds
International funds generally outpaced domestic funds again, continuing another familiar trend. The foreign large-growth, large-blend, and large-value categories all added between 9.5% and 10%, with growth barely outpacing blend and value. Also, foreign small/mid-growth added 13% for the quarter, while foreign small/mid-value gained 11.6%. The outperformance of small caps and mid-caps abroad mimics the trend domestically, as does the slight superiority of growth over value in the small- and mid-cap categories.

Latin America was, again, the best-performing region, with funds specializing in that area gaining 17%. The natural-resource-rich region continues to benefit from higher commodity prices. Nevertheless, analyst Bill Rocco  continues to warn about the volatility of these funds and views them as largely inappropriate for most investors.

Specialty-precious metals was the best international category, with a 21% surge. Nevertheless, analyst Karen Wallace  warns that the countercyclical aspect of gold and precious metals can make the category decline as fast as it surges when optimism over the economy is high and the geopolitical situation stable. Investors should also keep in mind that today they have a range of "hard asset" choices with which to balance their stock and bond exposure, such as real estate funds and funds that track broad-based commodity indexes.

Morningstar analysts view the money flow into international funds with mixed feelings. On the one hand, we are happy to see American investors gaining exposure to international markets and adding another element of diversification to their portfolios. On the other hand, we cannot help but think that short-term "performance-chasing" represents a significant portion of assets moving into international funds now. As always, we encourage investors to maintain international exposure as part of their long-term asset-allocation plans, as a means to increase returns and damp the volatility of their portfolios over the longer haul.