Course Correction

The first six months of 2006 offered little encouragement for mutual fund investors. Stock funds rose in the first quarter then sank in the second, winding up with average returns around 3% for the period. On the bond side, investors barely broke even as their income distributions were offset by falling share prices in the face of rising interest rates.

To guard against such times of sluggishness and possible market corrections, Kaye and Nick Flores of Altadena, California, spread their assets around. “Counting our retirement plans, the money held in taxable accounts, and the money in our children’s accounts, we hold 14 different funds,” says Kaye, 44, a marketing executive at a healthcare firm.

The Floreses have been investing in mutual funds since the 1980s. “We invest in our funds three times each month,” says Kaye. “That includes the money I invest at work, in the 403(b) plan.” This plan, similar to a 401(k), allows her to defer some income (and some income tax) by putting money into a mix of funds. “We don’t really miss the money we’re investing,” she says, because the outlays become just like any other item in the family budget.

The couple picks their funds with the help of Arnetta Tolley, an investment adviser at the Pasadena, California, office of Edward Jones Investments, a financial services firm based in St. Louis. “We meet with her once each quarter,” says Nick, 46, a semi-retired network engineer who is launching a new business, N.S. One Spa and Salon, in Altadena. “We may bring in funds for her opinion, or she might recommend some funds for us.”

The Floreses currently have some 85% of their mutual fund assets in stock funds while 15% is in fixed-income and cash. Among the stock funds, 49% is in growth, 36% is in growth-and-income, and 20% is in global and international funds.

They own a number of American Funds products including EuroPacific Growth Fund, which focuses on the largest international companies, and are increasing their ownership in New Perspective Fund, which invests in both U.S. and foreign stocks. The emphasis at New Perspective is on multinational companies that stand to gain from changes in international trade patterns, according to Tolley. The couple also owns Capital World Growth and Income Fund, which is a “conservative cousin” of New Perspective. Other holdings include The Investment Company of America, Fundamental Investors, and The Growth Fund of America, all of which emphasize domestic stocks.

Though the results for the first half of 2006 may have been unexciting, they could have been much worse. As of early August, there had not been a market correction — a decline in market price of at least 10%, but no more than 20% — in more than two years. But today’s triple threats of higher interest rates, inflation, and energy costs make such a correction a strong possibility in 2007. In times like these, where can you turn to get sustained mutual fund performance?

While it’s hard to predict which types of funds will do well, John Coumarianos, an analyst at Morningstar Inc., recommends investing in mutual funds that are diversified among different asset classes emphasizing past performance and experienced management.

Coumarianos recommends looking into foreign stocks. Morningstar’s category of Pacific/Asia stock funds that excludes Japan was up 13.68% in the first half, followed by Latin American (13.20%) and European (13.14%) stock funds, as investors continued to find better values and opportunities outside the U.S. Foreign stock funds have outperformed domestic entries every year since 2001.

Other categories investors should consider include:

Precious metals. These types of funds were the big winners, gaining 22.50% in the first half of this year. They invest heavily in mining stocks, especially gold mines. “Gold is viewed as an inflation hedge,” says Coumarianos. Inflation worries have contributed to higher gold prices in recent years; higher gold prices, in turn, have boosted the share prices of mining companies and the mutual funds owning their stocks.

Real Estate/Energy. Strong returns also were posted by real estate funds (up 12.44%) and natural resources funds (11.95%), which have large holdings of energy stocks. Real estate, oil, and natural gas are all expected to gain value in inflationary times, so these funds were popular. If you’re worried about a correction in 2007 driven by higher inflation, you might want to hold such funds in your portfolio.

Small companies. Among domestic funds, the small-value and small-blend (which hold a mix of small-company growth and value stocks) categories led the way, both gaining about 7% in the first half.

While the superior performance of precious metals, real estate, and natural resources funds can be attributed to inflation concerns, what explains the strong results from foreign stocks and, to a lesser extent, small U.S. companies? After all, even the domestic giants struggled much of the year. Funds holding large-company growth stocks, the darlings of the 1990s bull market, lost more than 1% in 2006, through June.

“We’re still seeing some rebound from the late 1990s,” says Coumarianos. “Back then, investors invested heavily in large growth stocks, especially tech stocks. Foreign stocks and small-cap stocks were all but forgotten, so they became undervalued.” The bear market of 2000 to 2002 demolished tech stocks, so investors turned to small caps and foreign stocks, trends that continue to run.

“Some foreign companies, especially in Asia and Latin America, participate in metals, mining, or oil,” says Coumarianos. “Those industries are attracting investors now after many years of neglect.” In addition, investors learned the risks of overloading on one type of mutual fund, so diversification into lesser-known areas has gained popularity.

Proverbial Profits
Another fan of American Funds is Kevin Davis, a certified financial planner with Consolidated Financial Services in Dallas. “I used to be a recruiter,” he says, “and I heard that it was hard to place money managers with that company. Only the top people got jobs there.”

Such selectivity has resulted in investment success. “The funds might be the turtle rather than the hare,” says Davis. “They may not have the best returns in any one year, but they’ll finish first over a long race.”

Among Davis’ clients hoping to reach the winner’s circle is Lawrence Powell, 42, senior pastor of Agape Family Worship Center in Rahway, New Jersey. “We have three children, ages 11 to 15, so some of my investing is intended to help pay college bills,” he says. “At the same time, I’m investing for my own retirement, which is long-term. And I’d like to leave an inheritance, too. As it says in Proverbs 13:22, ‘A good man leaves an inheritance for his children’s children.'”

To accomplish these multiple goals, Powell invests in mutual

funds through his employer’s 403(b) plan, where he has been maximizing contributions, and also invests in tax-advantaged 529 college savings plans for his children. “I’m mainly using stock funds for my retirement,” he says, “because the long-term returns are likely to be greatest there. But I’m somewhat conservative with the funds in the college account.”

Powell was an even more conservative investor up until a few years ago. “I explained that he has about 20 years until retirement,” says Davis, “and he can live for many years after that, so he really needs to invest with a long time horizon. Therefore, we have increased his stake in stock funds.” Historically, the long-term results from stock funds top those from bond funds.

Some of the American Funds on Powell’s list

are the same as those held by the Floreses: Growth Fund of America, Capital World Gr
owth and Income, Fundamental Investors, and New Perspective. But there are others as well. “Lawrence invests in New World and SMALLCAP World funds,” says Davis, “to get a good mix of non-U.S. stocks. Companies are doing well overseas, so investors can feel more comfortable with international funds.”

On the domestic side, Powell also has AMCAP Fund, which holds large-growth stocks. “In addition, he invests in American Balanced Fund,” says Davis, “which is more conservative because it holds bonds as well as stocks.”

What funds might appeal to investors who are worried about a correction next year? “Funds that tend to do better during market corrections are those that focus on providing income as part of their overall objective,” says Davis. “Such funds may be found in the growth-and-income, equity income, and balanced categories.”

Davis’ list of funds that have done well during previous market corrections include American Balanced, as well as The Income Fund of America and Capital Income Builder, two funds that hold dividend-paying stocks and bonds. (The latter fund has more global exposure.) Davis also cites American Mutual Fund and Washington Mutual Investors Fund, two stock funds that hold large companies likely to pay dividends. “As always,” he says, “part of a good investment program to offset market corrections would be a diversified portfolio that is not overweighted in any one industry.”

In Search

Of Income
It’s no surprise that interest rates are rising and are expected to continue doing so in the coming year. Coumarianos says investors should keep some money in bond funds even though the rising rates should devalue bonds. “An intermediate-term bond fund can be a core holding,” he says, “offering reasonable income with moderate risk. Funds such as PIMCO Total Return Fund and Fidelity Intermediate Bond Fund may be good choices.”

PIMCO Commodity RealReturn Strategy Fund also rates a favorable mention from Coumarianos. “It tracks the Dow Jones AIG Commodity Index so you get broad exposure to commodities, including oil and gas,” he says.

Coumarianos also says there’s value in large-cap domestic stocks, particularly those companies who have protected their competitive positions. His picks in the large-cap growth area include T. Rowe Price New America Growth, Vanguard Growth Equity Fund, and USAA Aggressive Growth. In the large-cap value category, picks include ICAP Select Equity Fund, Sound Shore Fund, and Weitz Value Fund.

A well-diversified mutual fund portfolio for these uncertain times should include old reliables such as large U.S. companies and high-quality bonds as well as new favorites that range from foreign stocks to small companies. A small (perhaps 5%) allocation to commodities and a similar allocation to a real estate fund might provide valuable protection in case inflation heats up and the market turns down.

Although inflation fears and geopolitical concerns have shaken stock markets lately, Tolley has little inclination to cut back on stocks in anticipation of a possible correction, especially for investors who are in it for the long haul. “When stock prices fall,” she says, “there are buying opportunities. At any kind of store, when is the best time to go shopping? During the semi-annual sales.”

B.E.’s best-performing Mutual funds

FUND NAME	TICKER SYMBOL	1-YEAR RETURN	3-YEAR RETURN	5-YEAR RETURN	MINIMUM INITIAL INVESTMENT	PHONE
LARGE GROWTH
Marsico 21st Century	MXXIX	23.41%	20.65%	12.93%	$2,500	888-860-8686
Columbia Marsico 21st A	NMTAX	22.63	20.47	12.52	1,000	800-321-7854
Amana Trust Growth	AMAGX	19.81	21.74	8.40	250	800-728-8762
Fidelity Fifty	FFTYX	18.56	10.16	7.61	2,500	800-343-3548
Dreyfus Prem Alpha Gr C	BSFCX	16.35	13.23	7.45	1,000	800-554-4611
MID GROWTH
Delaware American Ser A	DASAX	11.35	17.32	14.37	1,000	800-523-1918
Baron Partners	BPTRX	20.06	29.89	14.37	2,000	800-442-3814
Columbia Acorn Z	ACRNX	16.44	21.94	12.31	75,000	800-345-6611
Columbia Acorn Select Z	ACTWX	17.28	15.89	11.75	50,000	800-345-6611
Munder Mid-Cap Core Gr Y	MGOYX	12.41	20.28	10.82	1,000,000	800-438-5789
SMALL GROWTH
Royce Value Plus Service	RYVPX	30.00	28.78	22.75	2,000	800-221-4268
William Blair Sm-Cp Gr N	WBSNX	11.75	20.82	14.16	5,000	800-635-2886
UMB Scout Small Cap	UMBHX	16.16	20.30	12.35	1,000	800-996-2862
Excelsior Small Cap	UMLCX	18.03	20.67	11.97	500	800-446-1012
First Amer Sm Cap Sel Y	ARSTX	LIGN=”MIDDLE”>21.93	“MIDDLE”>20.24	11.15	0	800-677-3863
LARGE BLEND
MassMutual Sel Foc Val S	MFVSX	4.43	11.72	10.98	1,000,000	888-309-3539
Penn St Adv Sect Rot A	PSRPX	12.95	17.24	9.75	2,000	866-207-5175
Janus Contrarian	JSVAX	22.05	23.56	9.73	2,500	800-525-3713
CGM Mutual	LOMMX	13.62	18.67	9.11	2,500	800-343-5678
Mairs & Power Growth	MPGFX	8.03	13.00	9.05	2,500	800-304-7404
MID BLEND
Fidelity Adv LevCo Stk A	FLSAX	18.65	27.14	24.64	10,000	877-208-0098
Fidelity Leverage Co Stk	FLVCX	20.58	valign=”middle”>27.77	24.27	10,000	800-343-3548
CGM Focus	CGMFX	26.45	29.43	21.11	2,500	800-343-5678
RS Value	RSVAX	10.68	25.93	17.59	5,000	800-766-3863
Kinetics Paradigm	WWNPX	20.67	24.31	16.56	2,500	800-930-3828
SMALL BLEND
Bridgeway Ul-Sm Co Mkt	BRSIX	15.07	21.65	22.35	2,000	800-661-3550
Keeley Small Cap Value	KSCVX	31.10	29.79	18.02	1,000	888-933-5391
Royce Value Service	RYVFX	22.15	26.44	17.16	2,000	800-221-4268
Stratton Small-Cap Value	STSCX	16.21	25.54	16.72	2,000	800-472-4266
Pacific Adv Small Cap A	PASMX	44.49	39.03	16.62	1,000	800-989-6693
LARGE VALUE
Yacktman Focused	YAFFX	3.68	9.28	14.51	2,500	800-525-8258
Yacktman	YACKX	3.82	9.82	13.47	2,500	800-525-8258
Hancock Horiz Value Tr	HHGTX	16.13	20.12	11.80	1,000	800-259-1926
Fidelity Adv Cyclical Indst A	FCLAX	22.33	24.34	11.55	2,500	877-208-0098
Pioneer Cullen Value A	CVFCX	14.73	19.20	11.16	1,000	877-485-8586
MID VALUE
ICON Materials	ICBMX	35.29	31.37	16.63	1,000	800-764-0442
Nuveen NWQ Multi-Cp Val R	NQVRX	17.77	20.15	14.51	3,000	800-257-8787
Alliancebern Sm-Mid Cap Val A	ABASX	12.19	19.83	14.23	2,500	800-221-5672
Delafield	DEFIX	15.18	18.43	13.73	5,000	800-221-3079
Quaker Mid-Cap Value A	QMCVX	10.32	22.80	13.61	2,000	800-220-8888
SMALL VALUE
James Small Cap	JASCX	15.59	22.98	18.00	2,000	800-995-2637
DFA U.S. Small Cap Value II	DFAVX	20.13	26.83	16.94	2,000,000	310-395-8005
Mainstay Small Cap Opp I	MOPIX	9.91	25.41	16.92	5,000,000	800-624-6782
Pacific Cap Small Cap A	PCSAX	15.76	23.57	>16.68	1,000	800-258-9232
DFA U.S. Small Cap Value	DFSVX	19.77	26.50	16.66	2,000,000	310-395-8005
MODERATE ALLOCATION
Bruce	BRUFX	19.98	35.59	30.82	1,000	800-872-7823
Waddell & Reed Adv Asset Stat A	UNASX	38.80	20.37	12.68	500	800-366-5465
Ivy Asset Strategy C	WASCX	36.08	18.88	11.60	500	800-777-6472
ING T. Rowe Price Cap App S	ITCSX	9.74	14.15	10.49	0	800-366-0066
T. Rowe Price Cap Apprec	PRWCX	9.09	13.22	10.12	2,500	800-638-5660
WORLD STOCK
FUND NAME	TICKER SYMBOL	1-YEAR RETURN	3-YEAR RETURN	5-YEAR RETURN	MINIMUM INITIAL INVESTMENT	PHONE
Polaris Global Value	PGVFX	19.00%	23.15%	16.83%	$2,500	888-263-5594
Oakmark Global I	OAKGX	20.47	20.73	16.52	1,000	800-625-6275
Templeton Global Sm Co. A	TEMGX	14.10	24.51	14.71	1,000	800-342-5236
Vanguard Global Equity	VHGEX	22.33	22.96	13.55	3,000	800-662-6273
Evergreen Glob Opport A	EKGAX	29.16	28.61	12.90	1,000	800-343-2898
FOREIGN LARGE GROWTH
Columbia Marsico Intl Opp Z	NMOAX	32.65	23.01	13.31	1,000	800-321-7854
Fidelity Adv Div Intl A	FDVAX	25.78	23.35	13.01	2,500	877-208-0098
Marsico Intl Opp	MIOFX	31.62	22.94	12.97	2,500	888-860-8686
Principal Inv Intl Gr Instl	PITIX	31.85	27.17	12.57	0	800-547-7754
Janus Overseas	JAOSX	52.33	33.29	11.83	2,500	800-525-3713
FOREIGN LARGE BLEND
Fidelity Canada	FICDX	27.34	27.87	18.98	2,500	800-343-3548
Allianz NACM Intl Instl	NAISX	39.76	31.33	16.20	5,000,000	800-927-4648
Alliancebern Intl Gr A	AWPAX	25.11	27.30	14.56	2,500	800-227-4618
Rochdale Atlas	RIMAX	32.24	27.32	13.89	1,000	800-245-9888
Fidelity Intl Disc	FIGRX	26.99	25.46	13.10	2,500	800-544-6666
LONG-TERM GOVERNMENT
American Cen. Target Mat 2025 Inv	BTTRX	-12.65	3.42	8.94	2,500	800-345-2021
American Cen. Target Mat 2020 Adv	BTTTX	-9.48	2.34	8.45	2,500	800-345-2021
American Cen. Target Mat 2015 Inv	BTFTX	-5.84	1.37	7.51	2,500	800-345-2021
valign=”middle”>Wasatch-Hoisington U.S. Treasury	WHOSX	-10.65	1.93	6.77	2,000	800-551-1700
PIMCO Long-Term U.S. Gov’t In	PGOVX	-7.18	1.35	6.70	5,000,000	800-927-4648
INTERMEDIATE GOVERNMENT
American Cen. Target Mat 2010 Inv	BTTNX	-2.10	0.48	5.85	2,500	800-345-2021
Huntington Mtg Sec Tr	HMTGX	0.97	4.03	5.44	1,000	800-253-0412
DFA Intermediate Govt F/I	DFIGX	-2.22	0.75	5.42	2,000,000	310-395-8005
BlackRock Govt Inc Inv A	CCGAX	-2.03	1.27	5.37	1,000	800-441-7762
PIMCO Total Return Mortgage Inst	PTRIX	0.33	3.09	5.28	5,000,000	800-927-4648
SHORT-TERM GOVERNMENT
Federated Mortgage Inst	FGFIX	0.14	2.44	4.43	100,000	800-341-7400
Analytic S/T Gov Inc Inst	ANSTX	1.80	2.64	4.42	2,500	866-777-7818
Managers Interm Dur Govt	MGIDX	-0.16	2.25	4.37	2,000	800-548-4539
Marshall Govt Inc Inv	MRGIX	0.46	3.07	4.35	1,000	800-236-3863
Allegiant Govt Mortgage I	AUSIX	-0.02	2.32	4.08	0	800-622-3863
LONG-TERM CORPORATE BOND
Loomis Sayles Invm Gr F/I	LSIGX	3.52	6.66	11.02	3,000,000	888-226-9699
Delaware Extended Duration Bond A	DEEAX	-6.70	3.40	8.44	1,000	800-362-7500
Croft-Leominster Income	CLINX	0.75	4.30	6.69	2,000	800-551-0990
Vanguard Long-Term Bond Index	VBLTX	-6.79	1.91	6.61	3,000	800-997-2798
Vanguard Long-Term Invest.-Grade	VWESX	-7.70	1.96	6.61	3,000	800-997-2798
SHORT-TERM BOND
Phoenix Multi-Sector S/T Bd A	NARAX	1.58	3.23	5.33	500	800-243-4361
Thompson Plumb Bond	THOPX	0.95	2.85	4.94	2,500	800-999-0887
BlackRock Interm Bd Instl	PNBIX	0.18	1.49	4.73	2,000,000	800-441-7762
Ivy Mortgage Securities A	IYMAX	0.17	2.32	4.55	500	800-777-6472
Diversified Short HorInstl	DISHX	1.94	3.52	4.39	5,000	800-755-5801
HIGH-YIELD BOND
Loomis Sayles Instl Hilnc	LSHIX	8.99	14.11	13.22	3,000,000	888-226-9699
Fidelity Real Est H/I	F0000U*	6.40	11.25	12.32	2,000,000	800-544-8888
Delaware Pooled High-Yield	DPHYX	5.58	11.00	11.82	1,000,000	800-231-8002
WM High Yield A	CPHYX	10.66	10.76	11.25	1,000	800-222-5852
VALIC II High Yield Bond	F06PMT*	9.94	13.28	11.10	0	800-448-2542
MUNI NATIONAL INTERMEIDATE
Phoenix Ins Tax-Ex Bond Instl	HXBIX	0.83	2.62	5.26	100,000	800-243-1574
Evergreen Intm Muni Bd Instl	ESTIX	-0.25	2.90	5.13	1,000,000	800-343-2898
Delaware Tax-Free USA Interm. A	DMUSX	0.58	3.32	5.11	1,000	800-523-1918
Elfun Tax-Exempt Income	ELFTX	1.02	3.17	4.98	500	800-242-0134
Vanguard Hi-Yld T/E	VWAHX	1.77	4.03	4.93	GN=”MIDDLE”>3,000	800-997-2798