Barron’s | Not Quite Up, Up and Away

Not even a spectacular 11th-hour rally could get stock-market funds back up into the air in the second quarter. U.S. diversified equity funds dropped 0.35% in the three months, topping the Standard & Poor’s 500’s 0.39% loss in that time. Added to the familiar head winds–European debt problems, Middle Eastern violence and the aftermath of Japan’s natural- and man-made catastrophes–was the approaching conclusion of the U.S. Federal Reserve’s quantitative-easing program, which has bought billions and billions of dollars of government debt.

That didn’t, however, hurt bond performance much as long-term domestic fixed-income funds gained by 1.39%, an increase many thought impossible given the low level of rates at the start of the quarter. Some bond sectors really took off. General municipal debt, which was getting drubbed earlier in the year, provided a 4.03% return in the second quarter, a sign that the worst of the worries about state and municipal budgets may be receding. Taking on added credit risk paid off: High-yield muni funds rose by 5.16% and emerging-markets debt returned 3.26%, another strong showing.

And bonds continue to defy their critics. The domestic long-term funds gained 6.48% in the past 12 months while world-income funds, with a 2.54% second-quarter gain, have returned 11.56% in the past year. Although Pimco’s Bill Gross has been bearish about Treasuries, his $243 billion Pimco Total Return Fund (ticker: PTTRX) was up 1.86% for the period and 5.94% in the past year.

Still, stocks have come a long way, too, in the past year. After big outflows through 2009 and 2010, the U.S. diversified funds grew to $3.95 trillion in the second quarter, up from $3.87 trillion three months earlier. Since the midpoint of 2010, diversified equity funds have gained 31.66%. Among the stellar equity returns in that time are natural-resource funds, up 46.44%, science and technology, up 35.47% and telecommunications, up 33.33%.

Looking overseas has also been an effective strategy. The few types of stock funds in the black during the quarter were largely global and international. For instance, international large-cap core funds rose by 1.43% in the second quarter, putting their 12-month gains at 30.89%.

Not content with bonds’ steady gains or the dividends paid out by big foreign companies? Try volatility. It’s part of the recent onslaught of about 300 new exchange-traded products, some of them leveraged, that have arrived of late. Among them: the infant Velocity Shares Daily Inverse VIX Short Term (XIV), up a whopping 31% for the three-month period, and iPath Inverse January 2021 S&P 500 Short Term Futures VIX (IVO), up 22%. “These vehicles have attracted a lot of assets from institutions and financial advisors who want to short VIX futures,” according to Nick Cherney, co-founder and chief investment officer for VelocityShares, who used to develop iPath exchange-traded notes for Barclays Capital.

MORE-PROSAIC LONG-ONLY mutual funds that invest in large-, mid- and small-cap stocks didn’t do a lot during the quarter; most didn’t stray far from zero returns in one direction or another.

Growth held up better than value. Large-cap growth stocks climbed 0.29% during the quarter and 32.68% during the year. Large-cap value dropped 0.68% during the quarter but gained 28.33% for the year.

It was the same story for mid-caps. Growth eked out a 0.24% gain (41.15% over the past year) but value funds sank 0.96% although they were up 33.55% for the year. Small-cap value funds, which have been stars since the market started to rally in 2009, dropped 2.51% during the quarter but are up 32.03% since the middle of 2010. Small-cap growth funds were among the gainers, up 0.28% (43.77% for the year).

Virtus Small-Cap Sustainable Growth A (PSGAX), up 8.43%, excelled by concentrating on the highest-quality small-cap companies. Jon Christensen, one of the fund’s three portfolio managers, says they focus on companies with sustainable competitive advantages that are not capital intensive, have low debt, and can outgrow their markets in good and bad times. One refreshing example: Pool (POOL) makes up 5% of the fund’s assets. The wholesale distributor of swimming-pool supplies and related leisure products was able to grab a bigger share of the market during the recession since its revenue comes from the maintenance of existing pools rather than the construction of new ones.

Equity funds that specialize in a particular sector could not get off the ground; they fell 0.79%. The exceptions were health-care, real-estate and utility funds.

The top actively managed fund was Highland Long/Short Healthcare A (HHCAX), up 13.81% for the quarter and 26.6% for the last 12 months. Portfolio manager Michael Gregory says health care is undergoing the greatest structural change in 45 years, creating a new set of winners and losers The fund was short Community Health Systems (CYH), a hospital company whose stock has been under pressure because of its billing practices, and Almost Family (AFAM), a regional home-care provider, which has been hurt by concerns about possible reimbursement cuts that may used to reduce the federal deficit.

Gregory was long Caliper Life Sciences (CALP) because he believes the biotech and diagnostic company has some interesting lab automation and tissue-imaging products and that it could be an acquisition candidate in the rapidly consolidating life-science tools industry.

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