Most Mutual Funds Lag Blue-Chip Gains

While blue-chip stock indexes have come roaring back from their late-summer lows, most stock mutual funds aren’t enjoying the party all that much.

Indeed, by the end of trading Monday, only 339 of 3,166 actively managed funds tracked by Lipper Analytical Services were beating the benchmark Standard & Poor’s 500 index’s gain since Jan. 1.

Among more conservative funds, the situation is even worse. Only three of 215 equity-income funds are beating the S&P; this year.

In part, this is because many of these funds invest in small and medium-sized companies, unlike the S&P; index, which is made up exclusively of large-capitalization stocks. In recent weeks and years, large-cap stocks have clobbered their smaller counterparts.

But mutual fund managers and analysts say individual investor behavior is also partly to blame for their underperformance.

Retail investors pulled money out of many funds when the market was falling--especially in August--and are only now beginning to put significant amounts back in, just as the S&P; 500 is hitting new highs.

This means fund investors aren’t leading the market, but following it. It also means that rather than buying on the market dips--which many analysts thought individuals had learned to do--fund investors sold on this dip and began buying only after the new rally was underway.

Of course, the majority of fund investors may have sat tight. But at the margin, many people were selling when they should have been buying.

Not only does this violate the investing axiom to “buy low and sell high,” it forces fund managers to do the same, managers say.

Notes Robert Boyd, manager of the UAM ICM Equity fund: “I’ll probably see a flood of money when the market tops.”

This is particularly troublesome to so-called value managers like Boyd, whose stated mission is to stick with stocks they think are undervalued, based on earnings, assets or other measures.

For them, getting money now is a double curse. Not only does it come late, it comes at a time when the market has regained all of its losses and is about as pricey--based on price-to-earnings ratios and other measures--as it was prior to the summer market slide, said David Schafer, manager of the Strong Schafer Value fund.

This means they’ll get money just as they’re running out of places to invest it.

“It always happens this way,” said Gerald Perritt, editor of the Mutual Fund Letter, a Largo, Fla., newsletter.

“Mutual funds are a great way to invest,” he said. “But to some extent, the dummy down the block can tell the fund manager what to do” by pulling or investing money at the wrong time.

Not surprisingly, those few funds that are beating the S&P; year-to-date--such as White Oak Growth Stock, which is up 30.2% vs. 24.1% for the index--didn’t run into this cash flow problem.

Just the opposite. In August, during the heart of the market slide, White Oak Growth saw a net inflow of $70 million, said manager Jim Oelschlager. And in September, another net $25 million was invested in the large-cap growth fund. White Oak is well-regarded, and investors may have noticed it is one of the few funds that has beaten the S&P; 500 index on a five-year annualized basis.

With that money, Oelschlager was able to add positions in stocks that got creamed last summer, such as Morgan Stanley Dean Witter. Oelschlager built his stake in the financial services stock when it was trading in the low-40s range in early October. It closed Monday at $73.68.

Fund flows still haven’t quite recovered from their pre-summer peaks, despite the market’s autumn rally.

According to Trimtabs.com, a Santa Rosa research firm, mutual fund investors are expected to invest $11.7 billion more in stock funds in November than they redeem. While that’s an improvement from the $9.1 billion Trimtabs believes went into equity funds in October, it’s still 30% less than was invested this time last year.

It’s also well below the pre-summer months, when stock funds were routinely enjoying net inflows of about $20 billion--sometimes more.

What’s more, international stock funds continue to see flat to slightly negative fund flows. Only in the last few weeks have investors responded to the surging market, mutual fund companies report.

Trimtabs says U.S. equity funds took in an estimated $3.3 billion in the three days ended Thursday.

Vanguard Group, the nation’s second-largest mutual fund company, said its stock funds are now on track to take in more than $2 billion in November, which should put it back or close to its pre-summer levels.

Also, Cigna Retirement & Investment Services, the nation’s third-largest 401(k) plan administrator, said about 48% of the $500 million or so that was shifted out of stock funds into fixed-income funds in the summer was put back in recent weeks.

Analysts expect a major inflow of cash in late December and January, when mutual funds have finished distributing their taxable gains. (Toward the end of each year, funds tend to distribute gains to shareholders, exposing them to taxes. This causes some investors to hold off on year-end fund purchases.)

January also marks the end of seasonal tax-loss selling. (This is where investors sell money-losing funds for tax purposes, using those losses to offset capital gains elsewhere in their portfolios.)

After that, “I think the flows are going to be huge,” said Perritt of the Mutual Fund Letter. What’s unclear, however, is whether or not the market will be as richly priced as it is today.

Aside from investor behavior, few things have changed since the market’s earlier July peak.

And this, too, worries many fund managers--especially those who invest in out-of-favor sectors, such as small-cap stocks, foreign stocks and value-oriented stocks--which continue to lag the S&P; badly.

“Typically, when you see a bear market or a major correction, you see a change in leadership,” said Thomas McDowell, partner at money manager Rice Hall James in San Diego.

“I’m not sure we saw that today,” he said, noting that small-cap stocks, though they recently rallied, remain down nearly 8% year-to-date, based on the Russell 2,000 small stock index. “So it’s a bit scary.”

UAM ICM’s Boyd agrees.

Indeed, managers of large-cap growth stocks--one of the few segments of the fund industry that have done well over the last 12 months--continue to be optimistic about their fortunes. Value managers continue to be pessimistic. And small-cap managers, who saw an exciting mid-October rally peter out Nov. 6, are left wondering when they will ever see a sustained rally--at least one long enough to allow them to outperform the S&P; 500.

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Smaller Stocks Still Behind

The rising tide of Monday’s stock market surge raised most mutual fund boats, but U.S. domestic equity fund categories tracked by Lipper Analytical still significantly lag the benchmark Standard and Poor 500 index of major companies. Small-capitalization companies remain far behind the other domestic categories. Year-to-date total returns

S&P; 500 Index: 22.4%

Growth Funds: 18.1%

Balanced Funds: 11.8%

Growth & Income Funds: 11.6%

Capital Appreciation Funds: 11.6%

Equity Income Funds: 10.4%

Small Cap Funds: --7.5%

Source: Lipper Analytical