Mutual funds: A ride reserved for the strong at heart

If you feel as though your investment portfolio is in a free fall and now is time to pull the rip cord, you've got plenty of company.

Not many mutual-fund investors were able to remain aloft during the first quarter's stock-market plunge. But analysts warn those still invested in the market to consider riding it out.

Returns from diversified US stock funds fell by 10.1 percent, their biggest quarterly drop in nearly six years, according to fund-tracker Lipper Inc. Nor did international stock funds, whose popularity has mushroomed in recent years, provide a safer haven. World stock funds shrank by 9.6 percent. Those losses would have been even larger were it not for the weakening US dollar, which produces currency-translation gains in foreign investments.

Only two types of stock funds showed any buoyancy: short-bias funds and gold funds. Short-bias funds use hedging strategies that profit from declining markets. The strength of gold funds reflected investor concerns over a flare-up in inflation and the dollar's erosion. All told, less than 4 percent of some 12,700 stock funds tracked by Lipper posted positive returns in the first three months of this year.

Beginning in early January, stock funds tumbled across the board, driven by severe stresses in the US credit markets. A laundry list of woes engulfed the economy, including major mortgage debt write-downs by leading banks and record oil prices. From its peak last October, the S&P 500 fell more than 15 percent before stabilizing toward the end of the quarter.

"The market's certainly gone well beyond a normal correction. We're probably in a bear market, although I doubt it will be a prolonged one," says James Swanson, chief investment strategist with MFS Investment Management in Boston. "If the US has entered a mild recession, as I suspect, stocks should be signaling an economic recovery before year-end."

"It's a bit late in the game to get aggressively defensive," adds Les Satlow, portfolio manager with Cabot Money Management in Salem, Mass.

Despite the torrent of bad economic news, the winds are shifting in a more favorable direction, some analysts say. To fend off recession, the Federal Reserve cut the federal funds rate by two full percentage points, its most aggressive easing in two decades. The central bank averted a serious financial crisis by arranging the takeover of Bear Stearns, a troubled investment bank. It also opened up its "lender of last resort" spigot to major investment banks for the first time in history. The Fed's swift actions, which gave stocks a big boost in recent weeks, "have been hugely important in rebuilding investor confidence," says Mr. Satlow.

Recent fund-flow data underscore a high level of aversion to risk by investors. "We've seen heavy flows into money-market funds lately and steady withdrawals from domestic-equity funds," says Tom Roseen, senior analyst at Lipper.

In contrast, mixed-asset funds, a popular option among those with 401(k) corporate savings plans, continue to enjoy large inflows. These funds, which typically allot one-third or more of their portfolios to bonds and other fixed-income securities, fell only 6 percent for the quarter.

So what's next?

Many market strategists expect more turbulence in the weeks ahead. Yet those who remain bearish for too long run the risk of missing a recovery, says Eric Bjorgen, senior analyst at Leuthold Group in Minneapolis.

"The primary trend may be down for a while longer," he says, but the stock market has historically turned up well before recessions end. On average, recessions since World War II have lasted about 11 months. But the market has generally bottomed out about six months into a recession. By Leuthold's count, a recession began in late 2007 and should be largely over by this fall. In anticipation of a market rebound later this spring, the company raised its equity stake in its major asset-allocation funds in late January to 50 percent, up from 30 percent. Leuthold's portfolios are focused on industries such as agricultural products, energy, natural resources, industrial metals, and healthcare. "We like large-cap companies that have pricing flexibility in an inflationary environment and aren't sensitive to consumer spending," Mr. Bjorgen says.

For clues as to the market's direction, keep a sharp eye on financial stocks, one of the market's most beaten-down sectors, says Mr. Swanson. With the Fed likely to make another significant cut in the federal funds rate in the next month or two, "banks will have a widening of their net interest margins ... creating a greater willingness to lend," he says.

Still, investors should be wary of bargain hunting until market volatility subsides, says Fred Dickson, chief strategist at D.A. Davidson in Lake Oswego, Ore. "You'll continue to see significant mortgage and other types of consumer loan write-offs by banks" over the next two quarters, Mr. Dickson says. Another market damper: Corporate earnings are likely to be weaker than expected, he adds.

Unless you are many years away from retirement, stick with a diversified portfolio that has a conservative tilt and includes large-cap growth, value, and international asset classes, says Vern Hayden, president of Hayden Financial Group in Westport, Conn. A 50 percent commitment to stock funds, with one-third of that invested globally, should work out well over the next few years, he says. Mr. Hayden favors value-oriented managers who turn over their portfolios slowly and hold dividend-paying, large-cap stocks with a multinational flavor.

Investors relying on interest from CDs and money-market funds should be prepared for a drop in income. Six-month CDs, which yielded more than 4 percent a year ago are now being renewed at 2.5 percent or less. Even if long-term interest rates hold steady, money-market yields are sure to fall further as the Fed continues to lower short-term rates.

Other alternatives, such as bond funds, have increased appeal. "You are now being better compensated for extending the maturity length of your bond holding," says Morningstar research analyst Michael Herbst. Tax-exempt bonds, for example, have slumped because of exaggerated fears about the solvency of municipal-bond insurers. High-quality tax-exempt funds, whose yields are typically 10 to 20 percent below that of comparable Treasuries, are now yielding between 3 and 3.5 percent. That gives them an edge over short and intermediate government funds for investors in 25 percent (or higher) tax brackets. "High quality short-term muni-bond funds from Fidelity, Vanguard, and T. Rowe Price are worth a serious look," Mr. Herbst says. Long-term bond funds, on the other hand, are more vulnerable to inflation risks.

For risk-averse investors, Herbst also recommends "Ginnie Mae" funds, which hold fixed-income securities representing part ownership in a pool of mortgage loans. These pools are supported by the full faith and credit of the US government. That gives them stronger backing than mortgages insured by government agencies such as Fannie Mae or Freddie Mac. Ginnie Mae funds currently sport yields of close to 5 percent, considerably more than US Treasury Bond funds.