Tom Rosen is riding his motorcycle to work these days, rather than navigating the streets of Denver in his gas-guzzling SUV. A financial market analyst, Rosen said the sharp spike in energy prices is changing the daily choices he makes about driving as well as the prospects for the mutual fund industry he tracks.
"I cannot afford to be putting money in there," he said of his SUV. "Maybe we will get smart and get rid of these big gas hogs. It is a huge question."
As the third quarter came to a close, the big question facing individual investors was how powerful an influence high energy prices would exert on the financial markets in the coming months, according to Rosen, a senior research analyst with Lipper, which ranks thousands of mutual funds, and other experts. What is clear, according to money managers, is that the rise in energy prices affected mutual fund performance substantially during the third quarter that just closed on Friday.
Natural resources funds shot up more than 20 percent in the quarter and are up more than 50 percent over the past year. Global-oriented funds, especially those invested in countries that are major oil exporters -- including Mexico and Brazil -- vastly outperformed U.S. equity funds. As a group, Latin American funds led the way, soaring about 28 percent in the quarter, compared with a gain of roughly 3 percent for the Standard & Poor's 500-stock index, according to Lipper Mutual Fund Industry Averages.
Gonzalo Pangaro, portfolio manager of the $800 million T. Rowe Price Latin America Fund, said strong performance in the quarter continued a three-year winning streak for the sector. "We are seeing steady inflows into the region and into our Latin America fund," he said.
Tenaris, a company that makes steel pipes for oil and gas production in Argentina, Brazil, Mexico and Venezuela, was up about 75 percent, the hottest stock in Pangaro's fund. Petrobras, the giant Brazilian oil company and a core holding, was up 40 percent, he said.
Despite these gains, as well as healthy growth in the banking sector in Brazil and Mexico, Pangaro said that Latin America remains a volatile region for investors. He suggested that individual investors allocate only a portion of their mutual fund holdings to Latin America, or any other emerging market, despite strong performance and a rosy outlook.
"The biggest risk in Latin America is politics," Pangaro said. "Next year there are going to be presidential elections in both Brazil and Mexico. We are not looking for meaningful change in policies, but there is always that risk in Latin America. Investors have to be mindful that this is a risky market."
Japan's Rally Continues
Latin America was not the only foreign market showing promise. There were also strong signs of a financial recovery in Japan. After peaking in 1989 and then moving downward or sideways for years, Japanese mutual funds increased an average of about 20 percent in the quarter.
Experts said they anticipate the rally in Japan to continue, because its banking sector has finally recovered after many years of restructuring, and because Japanese stocks appear undervalued compared with equities in the United States.
Bill Kennedy -- portfolio manager of Fidelity's nearly $4 billion International Discovery Fund and an investment maven who has been watching events in Japan and the Pacific Basin for the past 14 years -- said excitement has finally returned to the Japanese stock market in the past several months. He cited government-led economic reforms that bolstered the banking sector and channeled more individual savings into productive investments.
Kennedy, whose international fund was up about 10 percent in the third quarter, recalled meeting with the president of a Japanese manufacturer in 2000 who kept an enormous amount of cash on the company's balance sheet because the banking system was dysfunctional and could not be relied upon for loans. When he saw that same executive recently, the story line had changed dramatically.
"Now the company is buying back stock and increasing its dividend and knows it can go to the banking system," Kennedy said. "The momentum of economic reform is really snowballing and starting to accelerate. You are starting to see that come to the forefront now."
David Warren, portfolio manager for the T. Rowe Price Japan Fund, said U.S. investors may be moving too slowly to get back into Japanese stocks and mutual funds to take advantage of what appears to be the beginning of a resurgence. While Japan has the world's second-biggest economy, Warren said there is only about $250 million in his firm's Japan Fund. The reason, he said, is that U.S. investors got burned when the Japanese stock market collapsed more than a decade ago and then failed to rally.
Recently, the best-performing Japanese stocks have been retailers, real estate firms and other domestic companies that do not rely on exports for profits. Major consumer electronics firms, including Sony and Cannon, have not performed as well, he said.
"The Japanese market has been fantastic," Warren said of the third quarter. "During the first half of the year, it was pretty dull, and now it has just exploded. Japan was lagging the rest of the world and it has woken up, with the incumbent prime minister having gone to the polls and having his policy of reform endorsed by the electorate. There are animal spirits in this market, and over time it will go up further."
Words of Caution
Joe Brennan, principal with the Vanguard Group, said that while mutual fund performance in domestic stocks may appear weak compared with the results from abroad, broad-based U.S. stock indices are up about 10 percent, their historic average, over the past year. While value-oriented funds performed slightly better than growth funds in the United States during the third quarter, the difference between them was small, he said. This marked a shift, since money managers with value-investment styles had been outperforming by a wider margin those who favor growth.
Investors need to be cautious about jumping into natural resources funds after their recent rapid rise, since they could pull back sharply if the outlook for energy prices stabilizes, Brennan said. Vanguard's energy fund was up more than 19 percent in the quarter, but he said individual investors need to avoid chasing past performance or letting their holdings become too heavily weighted in energy or any other single sector.
"Should your average investor have money in an energy fund? Not very much," Brennan said. Investors in broadly diversified funds already have more exposure to rising energy prices than they may recognize, he said. "We try to educate investors about looking across all types of investments and creating a balanced portfolio."
In addition to global funds, gold funds were standout performers during the third quarter, with the average price of precious metal funds increasing about 20 percent. "Gold has had a terrific run," said John Coumarianos, a mutual fund analyst with Morningstar Inc.
Various studies show that most individual investors in the United States do not own enough global mutual funds, Coumarianos said. But given their sharp quarterly rise, he questioned whether this was the right moment for investors to jump in.
Coumarianos said the only Morningstar mutual fund category that posted negative returns in the third quarter was the bear market sector. Those funds seek to profit by betting that stock prices will fall. But even the bear market funds declined only modestly, down between 2 and 3 percent, he said.
While nobody can predict energy prices with certainty, Lipper senior research analyst Rosen said that U.S. businesses would be hurt in the fourth quarter if the rise in energy prices continues to drive down consumer confidence, and that translates into weak spending during the holiday season. The risk is high, he said, that people will curtail discretionary spending on many items, since they will face higher gas prices and bigger heating bills. "People are nervous about what is going on," he said.
But looking back at third-quarter results, what struck many was the resilience displayed by financial markets around the world in absorbing sharply higher energy prices and natural disasters. "This quarter," Vanguard's Brennan said, "nothing has been a true dog."