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By Tim Smart
Washington Post Staff Writer
Sunday, October 4, 1998; Page H1

In recent years, it's been pretty easy to make money in mutual funds. You just mailed off your money to the largest fund groups, chose either a fund linked to one of the market indexes or a grouping of the biggest U.S. companies, then sat back and watched the money double, triple, even quadruple.

No more.

The quarter just ended should disabuse any mutual fund shareholder of the notion that somehow the economy entered a New Era in which stocks only go up, business cycles cease to exist and every citizen of China is a potential customer for Coca-Cola or Whirlpool refrigerators. From the beginning of July to the end of September, the average stock mutual fund lost 15 percent of its value. Strategies such as putting money into emerging markets or small, fast-growth companies that only serve domestic customers proved even more dangerous to the bottom line.

"Equity investing is a two-way street," said Robert C. Puff, chief investment officer for American Century funds, based in Kansas City, Mo. "Stocks go down as well as up."

Over time, academic studies show, stocks return more than any other investment. That's the mantra of the mutual fund industry, and it has been a siren song to many an investor throughout the 16-year bull market. But there are also times when owning stocks can be bad for one's financial health. The stock market lost 45 percent of its value in 1973 and 1974, for example.

If this is such a time – and the future, for the first time in years, is difficult to foretell – what then should mutual fund investors do?

Risk vs. Reward
There's no easy answer to that question, partly because no one can predict whether the months and years to come will be bad for stocks. But with corporate profits under pressure and the economy slowing at home and abroad, it seems a fair bet that the bounteous returns of the past few years may no longer be a sure thing. And risk, seemingly not an issue of concern for investors who drove stock price multiples to records before the midsummer plunge, may once again be a four-letter word.

"There's really been no reason not to take risk" in recent years, with most classes of stock rising in unison, said Theresa Hamacher, chief investment officer at Pioneer Investment Management in Boston. "I think that, going ahead, that is going to change a lot."

The mutual fund universe offers investors thousands of funds to suit just about any investment objective, or economic forecast, ranging from aggressive growth at the highest end of the risk-return spectrum to government bond funds at the lowest. Among the most popular of stock funds have been the large growth funds and those that mimic the performance of one of the market indexes, such as the Standard & Poor's 500. Then there are all kinds of balanced funds that mix stocks and bonds in differing amounts and specialty funds that invest in one particular industry, such as telecommunications, or a specific region of the world.

Throughout the bull market, it has been the largest growth-stock funds and index funds that have done the best, along with certain specialty funds such as those that buy stocks of companies in health care, technology and financial services.

Fidelity's Select Healthcare and Select Financial sector funds, for example, are among the top five best-performing funds during the past 15 years, even including this year's third quarter. And the Janus Fund, a broad-based stock that features large, well-known companies, is still up 8.13 percent for this year, despite an 11 percent dip in the third quarter.

Some of these long-term performers could still be good investments in the future, but if the market is in for a protracted downturn, advisers say one way to reduce the risk of a portfolio with a large component of stock funds is to add some income-producing investments, either through a bond fund or with funds that hold stocks that pay high dividends. These tend to mitigate the overall risk of investing strictly in stock funds.

But even that can be a dicey bet, as bond funds that invest in anything other than U.S. government bonds (say, corporate bonds) have fared badly in the recent market downturn. Income funds as a group lost 4.53 percent in the third quarter, although long-term corporate and government bond funds eked out a modest 1.36 percent return.

A 'Soft' Landing?
Divining the appropriate strategy for a changed economic environment depends a lot on what kind of economy and market climate unfolds in the coming months. If the economy can achieve a "soft landing" – a slowdown in growth but no recession – one strategy that might work is to emphasize funds that invest in what are called defensive stocks, which do well in slow-growth periods. But if the economy were to tumble into a full-blown recession, then different choices would pay off better, if history is any guide.

Salomon Smith Barney strategist Eric Sorensen has studied which industries do well in economic downturns. His conclusion? If it's a soft landing, load up on companies in the aerospace and defense sector, soft-drink makers, pharmaceutical firms, and savings and loans. Other industries that have tended to prosper in weak economic conditions are broadcasters, publishers and home builders.

There's a reason this group of industries does well when economies soften, analysts say. They tend to be makers of staples that consumers favor no matter what happens to the economy. People may crimp a little on their spending if the economy sours, but they will probably still watch "E.R." and guzzle Pepsi. The other industries, such as home building, do well when interest rates fall, as they often do in downturns (and as they are doing now).

These are also industries that have the preponderance of their customers in the United States. That will cushion them from the effects of the spreading global financial crisis. In the third quarter, some of these defensive groups rallied, with tobacco stocks, food stocks and health care holding up well.

"For the most part, these are local companies," said Ed Larsen, chief investment officer for Aim Advisors, a Houston-based mutual-fund management firm. "If you're selling pancakes in America, your end buyer is a fully employed American worker who eats out."

But some analysts think the market has already fallen far enough that it doesn't pay to be any more defensive.

"That was great advice six months ago," said Patrick Adams, who manages some of the Denver-based Berger funds. "We've had one of the worst corrections since 1929, and to go more conservative would be a mistake."

Adams's own experience managing funds shows just how different results can be even within the same fund family. The Berger Select, a highly concentrated fund that buys medium- to large-capitalization growth stocks (clothier Tommy Hilfiger is one holding), is up 32 percent through Oct. 1, while the Berger Balanced fund, which is almost evenly split between stocks and bonds, is up more than 13 percent.

Adams believes the market is shifting to a new cycle in which medium-size companies will outperform the multinational giants that have led the market for so long.

Salomon's Sorensen also is looking for a new class of stocks, and the funds that invest in them, to outperform. He favors so-called value stocks – those whose prices are at levels beneath the overall market averages and that have steady rather than rapidly growing earnings.

"My personal feeling is it probably won't be a full-blown recession," Sorensen said. "What does that mean for most people? Probably a defensive portfolio that is more focused on value investing."

Sorensen added that while he sees bargains in the market, not everyone will. "It depends on what you think. If you think the world is coming to an end, there's no value," he said.

Value funds, however, have done poorly in the recent market swoon. At a time when value funds are supposed to shine, they have been stubbornly leaden.

The Vanguard Windsor fund, one of the best-known and largest value-oriented funds, is down 11.15 percent for the first nine months of the year, according to Lipper Analytical Services. The Vanguard Index 500 fund, the largest of the funds that track the S&P 500 index, is up 5.95 percent over the same period. And in the third quarter, when Vanguard's index fund lost nearly 10 percent, Windsor dropped almost twice as much.

One reason value funds haven't done well yet is that there has been a "flight to quality" in terms both of big-name stocks and government bonds. That has led stock and mutual fund investors to names such as General Electric and Microsoft, which are easily traded, and away from the less-liquid smaller and medium-size stocks that populate value funds.

"It's akin to catching a falling knife" is how T. Rowe Price Small-Cap Value Fund manager Preston Athey described the recent market for value investors. "Is that what you want to do?" he asked, noting that August was the worst month for his kind of stocks vs. the broad market. "What's happened is the smaller the company, the more illiquid the company, the less in favor it is."

But with the latest downturn and the rush to safety by investors who have been shunning all stocks in favor of bonds and cash, even the giants, such as GE and Gillette Co., are beginning to suffer. The concern is that these companies have more exposure to overseas markets and that they may be too highly valued. Gillette, for example, has lost 40 percent of its value since mid-July. It recently announced that third-quarter earnings would be below analysts' expectations and that it would lay off 4,700 employees.

A Long Wait
The worry about international markets is not likely to end any time soon, given that 40 percent of the world is now in some stage of recession, according to economists. That will dampen an area of mutual fund investing that was hot earlier this decade, when emerging-market funds were star performers. But these risky investments are now among the most bloodied of all: Montgomery Securities' Latin America fund lost almost 40 percent of its value in the third quarter, while the Lexington Troika Russia fund had the distinction of being the worst-performing fund in the period, down almost 65 percent.

About the only international funds that have held up this year as a group are those investing in Europe, which are up almost 6 percent so far this year despite a rotten third quarter that saw the average European fund lose 17.27 percent. Many investment advisers believe Europe could still be a good place to invest, since the arrival of a common currency and broad restructuring across many industries should make European businesses more competitive.

Long-term, international investing has proved rewarding, with the average international equity mutual fund returning about 10 percent since 1983. While that is well below the 16 percent average annual return of the S&P index funds, it is about the same as the average domestic small-cap fund.

In times of turmoil such as these, some investment advisers are preaching an old gospel: diversification. That would include, for most mutual fund investors, a healthy dose of funds that invest in bonds or income-producing stocks that pay high dividends, such as utilities. Fidelity's Growth & Income fund, a popular fund that blends growth stocks and income-producing investments, for example, held up better this year than Fidelity's signature growth fund, Magellan. Fidelity Growth & Income was up 6.46 percent through Sept. 30, while Magellan was up 5.03 percent.

"We are typically conservative investors," said Pittsburgh financial adviser Steve Lee, who advises individuals and small businesses. "We typically run balanced portfolios" comprising 70 percent stocks and 30 percent bonds.

"We are stressing this is a time to be cautious and to stick to your game plan," he said. "We were never believers in the New Era scenario. We don't think you can throw 80 years of history out the window."

Still, that message has been a hard sell, particularly of late, with investors who own just a handful of big-name stocks making the most money.

"It's hard to tell somebody when they've been doing so well that it's not a smart investment strategy," conceded Oppenheimer Funds chief investment officer Robert Doll.

Indeed, getting investors to realize that the recent market history was the anomaly, and not steady, low double-digit annual returns over a long period of time, may be the hardest advice to peddle to shellshocked mutual fund investors, many of whom have known nothing other than a raging bull market.

Thomas Reilly, who monitors global value stocks at the Putnam family of mutual funds, said he believes funds of large-company stocks may still be better bets in the coming months for mutual fund investors, but it may be a different group of companies than the financial services and technology firms that have tended to dominate the market in recent times.

One group Reilly believes could prosper is the large, integrated oil companies. Although the price of oil is near historic lows, Reilly points out that the producing nations have been showing greater adherence to production quotas and these companies also have rock-solid balance sheets to weather any economic downturn. The other areas he favors are utilities and some parts of the personal computer industry, which seems to have learned to deal with falling prices.

"We're in a disinflationary environment," Reilly said. "In a disinflationary environment, when the economy is slowing, the relative earnings growth of utilities gets more attractive."

Indeed, domestically oriented telephone companies also fit into this theme, as do American health-care companies. After all, analysts point out, people will still make calls and pop pills to ease aches and pains in a down economy.

And for those investors who are truly worried that the growing foreign financial crisis will engulf the United States and lead to a global recession, there's always cash. Returns on money-market accounts are in the 5 percent range nowadays. While that pales beside the 30 percent returns that investors in the S&P index funds have enjoyed the past couple of years, it's double what the S&P funds have done to date this year.