To the surprise of investors and the delight of money managers, mutual funds this spring made money the old-fashioned way--by spotting bargains in the market.

In fact, this year's second quarter was a period in which all the old verities of investing yielded handsome returns: Stock picking paid off, value investing paid off, diversification paid off, small-company stocks paid off.

Most surprising, given recent history, 68 percent of mutual-fund managers were able to outperform the Standard & Poor's 500-stock index--a stunning reversal of the pattern of the 1990s, when the index, and the funds that track it, have regularly trounced most mutual funds, according to data compiled by Lipper Inc., which tracks the fund industry.

In this year's first quarter, by contrast, only 25.7 percent of active managers outperformed the S&P 500, Lipper found.

Funds that are constructed to mirror the S&P gained a relatively paltry 6.85 percent for the quarter, the smallest gain for any category of general equity funds, according to preliminary Lipper data.

The results left many fund managers and financial advisers with a warm glow last week, and several pointed to the results as an indication that indexation has limitations and that investors do better in the long run if they spread their money across different asset categories.

Most advisers believe in asset allocation, said Elissa Buie of the Financial Planning Group in Falls Church, "and it's very nice to be shown we were correct."

"It's very important for the public to see this, to say, okay, it is in fact true that what goes up comes down, that things work in cycles," she added.

In addition to the stellar performance of managed funds in general, the second quarter also saw greatly improved results from:

* Value funds, those that invest in stocks of solid companies that have been overlooked by the market or have been beaten down by temporary conditions or by factors that the firm has overcome. Equity income funds, which look for firms with dependable earnings and thus hold many such stocks, returned on average 9.07 percent for the quarter vs. a 7.13 percent average for growth funds.

* Emerging-markets funds, which invest in companies in developing countries. Hammered by the 1997 Asian crisis, these funds have bounced back strongly along with many of the Asian economies, especially Korea. Emerging-markets funds overall leapt 24.88 percent in the second quarter, pushing them to a 34.61 percent gain for the year so far. The average fund investing in Pacific Rim countries other than Japan rose 37.6 percent for the quarter, a performance that resulted in a 40.62 percent gain for the first half. Latin American stock funds rose 15.55 percent on average for the quarter, while China region funds soared 34.4 percent.

* Japan funds. After years of laboring in the economic doldrums, Japan seems to have inspired new confidence in investors with its efforts to reform its markets. Funds investing in Japanese stocks climbed 18.69 percent for the quarter and are up 38.23 percent for the year.

* Small-company funds. Stocks of small companies, which historically have yielded high risks but high rewards, in recent years have been yielding instead high risks and low rewards. That changed in the second quarter, as small-cap funds gained 15.65 percent and funds investing in tiny--micro-cap--companies shot up 22.06 percent on average.

In contrast, index funds, growth funds and technology funds, three of the hottest types over the past several years, lost much of their oomph in the quarter, though by historical standards their performance was hardly shabby.

In addition to the index funds' 6.85 percent average return, growth funds gained 7.13 percent and technology funds 14.56 percent. Another star performer of recent times, health and biotech funds, posted a mere 0.89 percent gain for the quarter.

Several money managers said they saw the second-quarter numbers as in part a rebound effect in a market that had become too heavily weighted toward growth.

"I would describe the relationship between growth and value [stocks] as a rubber band that had been stretched to an unsustainable degree in favor of growth" but began moving back to a more normal level of tension, said Brian C. Rogers, managing director of T. Rowe Price Associates Inc., the big Baltimore fund family.

Morningstar.com's Russel Kinnel was more blunt: "It was kind of the revenge of everything that's been getting the crap beat out of it."

Economic fundamentals also played a role, managers said.

In addition to the direct impact of the Asian recovery, stocks in basic industries--the kind favored by many value investors--benefited from the realization that world demand for their kinds of products likely would be recovering.

"It was as if this new view came over the market, that there is a lot of growth around the world, so cyclical stocks just took off like a rocket," said Jeffrey Molitor, director of portfolio review at the Vanguard Group.

But though it is seemingly far out of line with the general market in recent years, the second quarter isn't necessarily a fluke, Molitor added.

"The way I've looked at it is, we had such an extended period of large-caps doing as well as they did, with a really tight concentration of performance [among a small number of stocks], I guess I'd see that as more the anomaly than what we saw in the second quarter." The seeming inability of fund managers to beat the overall market recently has lent credence to those who argue that information dissemination has become so efficient that no one can outperform the market consistently. In this view, it makes the most sense simply to buy an index fund--while such funds don't beat the market, they don't underperform it by much, which is more than many active managers can say.

But even Vanguard founder John C. Bogle, a leading advocate of index funds, has suggested recently that the recent performance of the S&P 500, concentrated as it has been in a small number of top-performing stocks, may be in for a cooling-off period.

Bogle said recently that he thinks investors should look at total-market index funds, which would allow them to capture the rise in stocks of small and mid-size companies as well.

Several experts noted that the Lipper data and those of most other fund trackers don't take taxes into account, thus understating the value to taxable accounts of index funds as well as some deliberately tax-managed funds.

Index funds are "tax efficient" because they sell shares only when a company leaves the index, and thus they generate little in the way of capital gains, which must be distributed to investors. Index funds also have low fees because investment choices are automatic.

"I think . . . having a core of index funds can always make a lot of sense because there you're winning the battle on cost and you're winning the battle on taxes," Molitor said.

Among the 25 largest stock mutual funds, the top performer was the Growth Fund of America, which racked up a 12.29 percent gain for the quarter and is up 19.06 percent for the year. In second place among the big funds was the Fidelity Equity Income Fund, with a 10.58 percent quarter and a year-to-date gain of 13.24 percent.

The best year-to-date performer among the big funds was the Janus Fund. Though it chalked up only 7.29 percent in the second quarter, it has climbed 19.47 percent for the year.

The overall champion for the quarter was the World Equity Benchmark Shares Malaysia fund (WEBS-Malaysia), which turned in an eye-popping 122.01 percent gain. Following were the Matthews International Korea fund at 69.73 percent and the Matthews International Dragon fund at 69.56 percent.

In fact, every one of the top 25 performers on Lipper's list was some form of Asia or emerging-markets fund.

At the other extreme, Lipper found, the Profunds Ultra-Short OTC Investor Shares fund fell 22.83 percent and the Prudent Bear Fund, 13.42 percent.

The weak performers were concentrated among funds focusing on Europe, gold and the health-care industry.

By categories, some of the top funds were Berger New Generation Fund (capital appreciation), up 30.57 percent; Frontier Equity Fund (growth), up 35.16 percent; Liberty Crabbe Huson Special A fund (mid-cap), up 29.61 percent; MAS Small Cap Growth Institutional fund (small-cap), up 39.65 percent; Bridgeway Micro Cap (micro-cap), up 35.74 percent; FPA Perennial Fund (growth and income), up 29.16 percent, and Phoenix-Engemann Value 25 Fund (equity income), up 19.26 percent. The MAS Small Cap Growth was the best-performing domestic general equity fund, followed by the Bridgeway Micro-Cap and Frontier Equity.

The Test of Time . . .

The five best-performing mutual funds among the 25 largest all managed to beat Vanguard's 500 Index fund this quarter . . .

In percent, for the quarter March 31 to June 30, 1999

Vanguard 500 Index 7%

Growth Fund of America 12.29%

Fidelity Equity Income 10.58%

Washington Mutual Investment 9.39%

Investment Co. of America 9.21%

Vanguard Windsor II 8.79%

. . . but if you invested $1,000 in each of the funds five years ago and held on to them, the index fund would have given you the best return.

From June 30, 1994 to June 30, 1999

Vanguard 500 Index $3,406

Growth Fund of America $3,124

Fidelity Equity Income $2,681

Washington Mutual Investment$3,053

Investment Co. of America $2,873

Vanguard Windsor II $2,973

SOURCE: Lipper

NOTE: Figures reflect cumulative total reinvestment performance.