By Jonathan Burton, CBS.MarketWatch.com
SAN FRANCISCO (CBS.MW) - Mutual-fund investors take note: It's safe to look at your quarterly statement again.
For the first time in 18 months, U.S. stock funds have posted double-digit average gains in this second quarter. Investors cheered signs that declining interest rates, income- and dividend tax relief, fewer corporate defaults and improving consumer sentiment were boosting economic recovery.
Additionally, a quick end to the Iraq war, bond yields at generational lows and the sense that stock prices had become too cheap also whetted investors' appetite for risk.
U.S. diversified stock funds rose 17.6 percent on average in the quarter through June 26, based on preliminary data from fund-research firm Lipper.
It didn't much matter what fund managers held. Large, medium and small-company shares all gained, with a slight bias to value stocks over growth, in what amounted to a one-size-fits-all rally.
"Stocks as an asset class seem to be back," said manager Bill Nygren of the Oakmark fund /zigman2/quotes/203815081/realtime OAKMX +1.69% , which rose 14.7 percent through Friday, and Oakmark Select /zigman2/quotes/207233272/realtime OAKLX +1.59% , which gained 14.8 percent, largely on the strength of consumer-related holdings.
"There was an awfully large amount of money on the sidelines," he said. "There is still a large amount of money on the sidelines. The positive effect that would have on the stock market is still ahead of us."
Small-company growth stock funds were the biggest quarterly gainers, Lipper reports, up 22.5 percent on average. Small-cap value was close behind with an average rise of 21.6 percent.
Value strategies dominated both mid- and large-cap funds. Mid-cap value funds added 20.6 percent versus 18.3 percent for mid-cap growth. Large-cap value funds rose 17.9 percent, while large-cap growth funds trailed the pack with a nonetheless respectable 14.5 percent average gain.
Several of the largest mutual funds lagged the average stock-fund return. The $63.2 billion Vanguard 500 /zigman2/quotes/209016161/realtime VFINX +1.06% , which tracks the S&P 500 Index, gained 16.7 percent through June 26. Large-Cap Core Fidelity Magellan /zigman2/quotes/204856871/realtime FMAGX +0.83% , the biggest actively managed U.S. stock fund with $61.7 billion in assets, was up 15.6 percent. Among large-cap value funds, $46.3 billion American Funds Washington Mutual /zigman2/quotes/208118063/realtime AWSHX +0.71% gained 17.2 percent.
The rally's broad power impressed portfolio managers and market analysts, particularly after a dismal first quarter in which the average diversified U.S. stock fund lost almost 2 percent.
But even as the quarter began, some market-watchers believed that investors had oversold stocks after three disappointing years. In fact, clues of changing sentiment appeared in mid-March, toward the end of the first quarter, when major market indexes started to climb after the Iraq war began.
The S&P 500 Index, for example, has gained 23 percent since flirting with the 800 level on March 11. The small-cap Russell 2000 index, meanwhile, is up roughly 30 percent from its mid-March low.
"The market got to be so risk-averse," said Kenneth Abrams, co-manager of the Vanguard Explorer fund /zigman2/quotes/205808530/realtime VEXPX +1.31% , which gained 21 percent over the past three months. "I had thought we'd been getting set up for a rally. I didn't know it was going to be this far, this fast."
But while speculative investments including small-caps and technology were winning percentage points, some more sedate strategies were gathering dollars.
Conservative Lipper fund classes including Equity Income, Balanced, Real Estate and Utility each attracted significant cash inflows. These portfolios also posted tidy gains, most notably utility funds, up 18.2 percent. That such staid, value-oriented funds are popular suggests that investors are searching for middle ground - still uncertain if this recovery is real.
Overall, shareholders poured an estimated $28.5 billion into U.S. stock funds in the quarter through June 19, a positive trend not seen since the first quarter of 2002, according to TrimTabs.com.
Still, said Lipper research analyst Jeff Tjornehoj, "Fund investors are tending to play this one close to the vest. There's a lot of hurt out there that's not easy to get over."
The most daring investors found plenty of chances to take. Small-company stocks often lead the charge out of economic recession, as investors become more willing to speculate in unproven businesses. The second quarter was no exception.
A rising optimistic tide lifted all small boats. The best-performing small-cap fund in the quarter - and the biggest gainer of all -- was Apex Mid Cap Growth, up 78.1 percent through June 26.
Meanwhile, Dreyfus Small Company Value /zigman2/quotes/206612074/realtime DSCVX +1.72% , up 40 percent, was the quarter's best small-cap value portfolio, and ProFunds UltraSmall Cap Investors /zigman2/quotes/206755251/realtime UAPIX +2.34% took top small-cap core fund honors, up 50 percent.
The Apex fund --- which despite its name is classed as small-cap growth -- relied on technology and Internet stocks such as Netflix Communications /zigman2/quotes/202353025/composite NFLX +2.05% , Tivo and Pacific Internet . These and other holdings soared off low bases in the quarter and catapulted return skyward.
"All the factors, from luck to skill -- everything came together," said Suresh Bhirud, the fund's manager.
But with only about $400,000 in assets - much of that Bhirud's own money -- Apex is a tiny fund that warrants hefty skepticism. It may have had a great quarter, but it's lost 13 percent annually over the past decade, compared to 10 percent yearly gains for the S&P 500, with almost three times the benchmark's risk, according to Morningstar.
More calculated risk-taking paid off handsomely in the quarter for Fidelity Leveraged Company Stock. /zigman2/quotes/203575147/realtime FLVCX +0.42% .
The $241 million mid-cap core fund gained 44.4 percent through June 26, better than all of its Lipper mid-cap category peers. Manager David Glancy's concentrated portfolio included big winners such as AES /zigman2/quotes/209256253/composite AES -2.21% , EchoStar Communications /zigman2/quotes/207505872/composite DISH -0.93% and Level 3 Communications .
Another attention-grabber was the multi-cap core Reynolds fund , a go-anywhere portfolio that climbed 57.1 percent over the past three months.
Manager Frederick Reynolds held fast to shares of high-flying technology companies including Vitesse Semiconductor and Rambus /zigman2/quotes/208867483/composite RMBS +1.36% , which soared from low bases. Holdings in widely traded Intel /zigman2/quotes/203649727/composite INTC +0.19% and Home Depot /zigman2/quotes/208081807/composite HD +1.07% , among other similar stocks, also performed well for the $16 million fund.
But like the Apex fund, Reynolds offered a bright quarter with a dark past. Its 28.2 percent average annual loss over the past three years trails the S&P 500 by 17 percentage points each year, Morningstar reports. That's worse than all but 5 percent of its category, with more than twice the benchmark's risk.
Pop of the top
Indeed, the strong upward trajectory that propelled funds like Apex and Reynolds struck some market observers as more of a relief rally than any endorsement of improving fundamentals.
"We like long, smooth moves rather than very rapid increases in stock prices. It leaves you nervous that people are somewhat chasing returns," said John Brennan, chairman of fund giant Vanguard Group.
"Investors are under the impression that there's such tremendous stimulus that people say the second half is going to be good," added Jean-Marie Eveillard, the veteran co-manager of the First Eagle Overseas fund /zigman2/quotes/209014684/realtime SGOVX +0.35% , which owns some U.S. stocks. "Maybe for a while we'll have the illusion of a return to prosperity, but I have serious doubts."
Expectations for economic prosperity encourage investors to hope for portfolio prosperity. Yet even after this resoundingly upbeat quarter, growth-stock funds still show depressing, double-digit three-year losses. Large-cap growth funds have fared worst, tumbling roughly 20 percent annually on average since June 2000. For value strategies over that time, only mid-cap- and small-cap funds are in the black.
It's a grim reminder of just how far shareholders still have to go before they ever return to how things used to be.