Mutual Funds: Net, Small Caps Big Winners

A year after Wall Street marked the end of its grueling bear market, stock mutual funds — particularly Internet and technology shares — are enjoying strong returns again. But investors should be careful about diving head first into these investments.

Since the main stock gauges hit multiyear lows on Oct. 9, 2002, the average return for U.S. diversified stock funds has climbed 40.5 percent through Oct. 9 of this year, according to fund tracker Lipper Inc.

That is ahead of the Dow Jones industrial average's 33 percent gain and the Standard & Poor's 500 index's 34 percent rise during the same period, although the fund performance trails the Nasdaq composite's 72 percent advance.

"By and large, people are optimistic the recovery is for real at this point," said Jeff Tjornehoj, research analyst at Lipper Inc. "But I would caution people not to swing their allocations too suddenly."

Tech, Telecoms, Show Gains

Smaller companies' shares were the big winners, with small-cap and mid-cap stock funds returning 54.3 percent and 46.4 percent, respectively, compared to returns of 33 percent for large-cap funds.

Broken down by sector, Internet and semiconductor funds dominated, led by offerings from ProFunds (returns averaging 188 percent to 311 percent); and Jacob (277 percent for its Internet fund).

They were followed by technology and telecommunications sector funds managed by companies such as Fifth Third (about 170 percent), Firsthand Funds (more than 140 percent) and The Oak Associates' Black Oak (133 percent).

"Investors have started pinning their hopes on businesses starting to pick up the slack," Tjornehoj said. "We had been a retail-driven, consumer-focused economy during the bear market. We're getting signs that business, especially the production side such as semiconductors … and Internet software services, are starting to get a foothold once again."

Similarly, small- and mid-cap funds tend to outperform in the early stages of an economic recovery as smaller companies often see more explosive growth than bloated, large companies with wide-ranging as well as international businesses, analysts said.

Are the Best Days Over?

But financial planners caution against overoptimism and concentrating assets in a few "winning" sectors. That's because investors are rarely successful in timing the market and could suffer heavy losses for their mistakes.

Karl H. Romero, a certified financial planner in Santa Ana, Calif., notes that Internet and small-cap stocks could perform well for a while but might have already seen their best days.

That's because, as the economic recovery continues, other lagging sectors such as large-caps will start to see gains. Niche areas such as the Internet, meanwhile, will continue to bring substantial risks since they lack other businesses to cushion losses in case of failure.

"You're better off to stay well-diversified among the major sectors and go for consistent returns. The worst thing they can do is chase returns," said Romero.

Lighten Up in Bonds

Tjornehoj agreed. He noted, for example, that many investors might want to consider lightening their allocations in bonds, particularly those with longer maturities, because of the growing risk of rising interest rates.

But because investors might be tempted to unload too much of their bonds, Tjornehoj suggests focusing on an investor's specific goals, such as saving for retirement or saving money for college, and tailoring investment decisions to those.

During the first year of the bull market as the economy began showing signs of recovery, U.S. domestic bond funds averaged a return of 9.1 percent, according to Lipper.

"Find an investment strategy and stick with it," Tjornehoj said. "Make an allocation perhaps once or twice a year, but don't make drastic changes in strategy."

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