Mutual funds squeezed out small gains in the second quarter of 2005 after a lackluster start to the year, as inflation remained tame and investors seemed to shrug off concerns about surging energy prices.
U.S. diversified stock funds, which are the most common type of mutual funds, posted a return of 2.32 percent for the second quarter as of June 30, compared with a negative return last quarter. But analysts say investors should still be cautious.
Whether positive returns continue depends on volatile oil prices and on how much the Federal Reserve raises its benchmark short-term interest rate this year, analysts said. On Thursday, the Fed bumped up the short-term interest rate by a quarter percentage point for the ninth time this year, bringing it to 3.25 percent.
"It's the magnitude of changes people are concerned about," said Tom Roseen, a senior research analyst at Lipper, the mutual fund research company that released the latest preliminary numbers. "If the Fed decides to tighten more aggressively, both in time frame and in magnitude, that could put a strain on the market as a whole."
People got nervous in the first quarter of 2005, as consumer prices rose more quickly than in previous months. Investors worried that the Fed would raise its short-term interest rate more aggressively to curb the risk of inflation. The result: U.S. diversified stock funds saw negative returns of 2.52 percent.
But in the second quarter ended June 30, investors relaxed a bit and things got a little less dismal. Consumer prices fell in May, as rising energy prices tapered off. The Fed raised the short-term rate in May by a quarter percentage point, which was in line with previous increases over the past year.
"People are saying, 'Okay, I'm ready to go play in the equity markets again," Roseen said.
The cautious-but-willing investor sentiment carried over to the bond market. Normally, inflation hurts the value of bonds, making the fixed rates of existing bonds less attractive. But as the threat of inflation declined and it seemed as if the Fed wouldn't do anything drastic, bonds gained strength in the second quarter, with general U.S. Treasury funds posting a return of 4.56 percent as of June 23.
"The Treasurys seemed to really be the cat's meow," Roseen said. "People jumped back in wholeheartedly when they saw inflation was not as big a concern."
As of June 30, the second quarter's top three overall performers were ProFunds Real Estate UltraSector Fund, with a 20.36 percent return; ProFunds Mobile Telecommunications UltraSector Fund, with 18.17 percent; and ProFunds Biotechnology UltraSector Fund, with an 18.01 percent return.
Some sectors did particularly well in the second quarter. Real estate performed best, with a return of 13.15 percent this quarter. The utility sector had the second-highest return, at 7.3 percent.
And then there were the losers. Ameritor Investment Fund, which invests in small-cap growth companies, posted the worst return: negative 25 percent. ProFunds Basic Materials UltraSector Fund posted a 14.18 percent negative return, followed by Corbin Small-Cap Value Fund, with an 11.79 percent negative return.
Investors still expect the Fed to continue steadily raising its benchmark interest rate, Roseen said. But they no longer worry about drastic or unexpected increases, so they are willing to take more risks.
That could explain why in this quarter, growth funds, or those that invest in companies that seem ready to expand, beat out value funds, which invest in stocks that may be more established but are out of favor and considered underpriced by fund managers.
Small-cap growth funds posted a return of 3.76 percent, the highest out of the diversified stock funds for this quarter. Small-cap core funds were next in line, with a 3.29 percent return. The large-cap value fund fared the worst, with a return of 1.02 percent.
"In the first quarter, investors felt there was a cyclical upturn going on, so they were more into the value funds," said Christine Benz, associate director of fund analysis at Morningstar Inc., an investment research company. In the second quarter, she said, investors became more interested in companies poised to grow.
That meant investors began to turn their attention to the health and biotechnology sector as well as the science and technology sector, both of which largely invest in growth companies. Health and biotechnology saw a return of 6.67 percent this quarter. Science and technology posted a return of 3.25 percent.
The funds improved their chances in the markets by investing in more than one area of health care and biotechnology, Roseen said.
"These funds diversified their subsectors," said Roseen. "They used to just focus on biotechnology or pharmaceuticals, and now they are focusing on both."
Although investors were more willing to take risks this quarter, many still wanted a guaranteed income. Investors had a big appetite for real estate stocks and utility stocks because they typically pay the highest cash dividend, Roseen said.
Investors who like to put money in stocks outside the United States were no doubt disappointed by the dismal performance of international funds, most of which showed negative returns. World stock funds, or those that invest money in foreign markets, showed a return of 0.40 percent, mostly thanks to Latin American funds, which posted a return of 10.29 percent, bolstered by Brazil's and Mexico's production of raw materials.
"Brazil kept a lid on inflation, and they have great results from the rise in oil," Roseen said.
So, after a dreary first quarter followed by small gains in the second, investors are waiting for signs of where the economy is headed next. Inflation could still be a risk.
Energy prices could be a concern in the immediate future because they affect investor appetite for stocks, said Sam Stovall, chief investment strategist for Standard & Poor's Equity Research Services. Oil prices topped $60 per barrel in trading a week ago. Investors know that oil prices are volatile, but if they stay up for a long time, that could cause uncertainty in the markets.
"If you have to pay more at the pump, it leaves you with less to spend at the mall," Stovall said. "As a result, if consumers, which represent two-thirds of the U.S. economy, end up engaging in reduced discretionary spending, that has a negative impact on corporate earnings, consumer sentiment and, as a result, equity share prices."
Also, second-quarter earnings would affect mutual fund returns in the third quarter, he added. First-quarter earnings, released in the second quarter, were better than expected. This helped second-quarter mutual fund returns.
And then there's the fact that it's summertime. Mutual fund returns tend to decline in the third quarter.
"Investors focus more on their tans than their portfolios," Stovall said.
But the expected slow season doesn't mean investors should take their money out of the market, he said. It could provide a good entry point for newcomers because stock prices may become a bit depressed.
Someone who is already invested in the stock market should just wait the summer out, Stovall said. "Chill out, don't worry, it's not a cause for concern."