Quarterly Fund Review: Tortoise Tramples Hare

The best thing about the third quarter is that it's over.

Stock funds were soaked in red ink, pummeled by the potent combination of a sagging economy, slipping corporate earnings and the confidence-sapping effects of Sept. 11's terrorist attacks. Only bond funds, the boring but capital-protecting alternative to stocks, posted a gain -- and then only a scant one.

The average taxable bond fund gained about 1% in the third quarter, compared with a 17% loss for the S&P 500 and the average U.S. stock fund. Over the past 12 months, bond funds are leading stock funds by more than 33 percentage points; they even have an edge over the past three years.

The average U.S. stock fund is now down more than 27% over the past 12 months, far worse than any calendar-year loss dating back to 1970. The worst losses continue to be suffered by tech- and tech-stuffed growth funds, which topped the sales charts last year.

"I don't think [fund investors] have seen a decline of this magnitude in the past 20 years or so," says Scott Cooley, a senior fund analyst with Chicago fund-tracker Morningstar.

Despite the bleakness of the past 18 months, the relative stability of tech-light value funds and bond funds does seem to underscore the relevance of the fund world's oldest saws: Spread your money beyond the sizzling sector or style of the day and don't invest a dime in the stock market if you think you'll need it within five years. Of course, that will provide little solace when you get your third-quarter account statement in a couple of weeks.

Let's Hear It for Bonds! Stocks relegated to second-class status
Fund Category	Q3*	1-Year Return	3-Year Return
Taxable Bond	0.9%	6.2%	4.1%
S&P 500	-16.7	-28.9	0.2
U.S. Stock	-17.1	-27.1	3.3
Foreign Stock	-19.1	-32.1	0.5
Source: Morningstar. *Returns through Sept. 25.

A glance at how various sector-fund categories fared illustrates the breadth of the stock market's malaise. Every sector-fund category had lost ground in the third quarter through Sept. 25, according to Morningstar. The hardest hit were tech funds, whose 34% average tumble capped a breathtaking 70% fall over the past 12 months. Tech-heavy communications funds and natural resources funds, hurt by rich valuations and falling oil prices, each lost 21% in the third quarter.

Real estate funds, which invest primarily in sleepy, dividend-rich real estate investment trusts, or REITs, fared best, with a 5% loss on the quarter through Sept. 25.

Value, the Underwater Haven Value funds lose ground, but less than tech funds
Fund Category	Q3*	1-Year Return
Small-Cap Value	-11.8%	3.1%
Mid-Cap Value	-12.7	-2.6
Large-Cap Value	-14.2	-11.9
Small-Cap Growth	-20	-36.3
Large-Cap Growth	-21.5	-45.3
Mid-Cap Growth	-23.5	-46.7
S&P 500	-16.7	-28.9
Source: Morningstar. *Returns through Sept. 25.

The only tech fund that finished the quarter in the black was the (PDISX Quote)Potomac Internet Short fund, which rang up a spectacular 74% gain thanks to its strategy of shorting, or betting against, Net stocks. Shorting involves selling borrowed shares, hoping to profit by buying and returning them at a lower price down the road.

The tech funds that fell furthest in the third quarter were those that owned Net stocks, like the (BTECX Quote)Berkshire Technology and (ATCHX Quote)Amerindo Technology funds, both of which have lost more than their value since June 30.

A similar pattern played out among diversified funds: Growth funds with big bets on tech stocks fell harder than tech-light value funds -- but all fell to varying degrees. Large-, mid- and small-cap growth funds each fell more than 20% on average in the third quarter. Their value peers fell 12%, 13% and 14%, respectively, on average.

The Opposite of Hot Every sector lost ground in the third quarter
Sector Fund Category	Q3*	1-Year Return
Technology	-33.8%	-69.6%
Communications	-21.3	-55.6
Natural Resources	-21.3	-16.8
Health	-14.7	-25.9
Financial Services	-14.6	-5.9
Utilities	-10.9	-20.2
Real Estate	-5.4	5.3
S&P 500	-16.7	-28.9
Source: Morningstar. *Returns through Sept. 25.

The growth funds that fared best were those whose strategies entail shorting, like the (POTSX Quote)Potomac OTC Short fund, which rose 38% in the third quarter, and the (IADAX Quote)Invesco Advantage fund, which fell only 10%. Many of the biggest losers suffered from outsize tech bets. The (MAFOX Quote)Merrill Lynch Focus Twenty and (VWMDX Quote)Van Wagoner Mid-Cap Growth funds both have most of their money in tech stocks; each fell about 48% in the third quarter. Both are down more than 80% over the past 12 months.

Value funds were an imperfect haven, offering lower losses if not gains. Those that stuck with traditionally cheap sectors fared best. The (CFIMX Quote)Clipper and (SEQUX Quote)Sequoia funds, which favor financial stocks, fell less than 5% in the third quarter. Techier value funds, like the (JFVAX Quote)John Hancock Focused Relative Value and the (JSVAX Quote)Janus Strategic Value funds, fell more than 25%.

Bond funds fared best, though they were not without risk. Fairly vanilla corporate and government bond fund categories stayed in the black, between their monthly income and price appreciation. Intermediate-term government funds and international bond funds led the way, with a 3% average gain in the third quarter. Intermediate-term bond funds, a core bond holding in most portfolios, gained 2.3% and are averaging an 11% gain over the past 12 months.

But riskier fare, like high-yield, emerging markets and multisector bond funds, all lost money in the third quarter.

Strong Bonds Even bond funds aren't infallible
Bond Fund Category	Q3*	1-Year Return
Intermediate-Term Government	3%	11.6%
International	3	7.4
Short-Term Government	2.7	10.1
Long-Term Government	2.7	11.6
Short-Term	2.4	10.1
Intermediate-Term	2.3	11.1
Long-Term	1.1	10.1
Ultrashort	0.9	5.1
Multisector	-1	1.2
High-Yield	-4.3	-9.4
Emerging Markets	-5.7	3.2
Avg. Stock Fund	-17.1	-27.1
S&P 500	-16.7	-28.9
Source: Morningstar. *Returns through Sept. 25.

Bond guru Bill Gross, lead manager of the top-selling (PTTAX Quote)Pimco Total Return fund, proved his mettle. His intermediate-term bond fund topped all of its peers with a 4.2% gain in the third quarter. The fund is up 13.7% over the past 12 months, compared with a 27% fall for the average U.S. stock fund.

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The tattered high-yield bond fund category stands out among the bond-fund losers. The average junk bond fund has lost money over the past one and three years, thanks to a rash of bankruptcies among upstart telecom outfits and increasingly risk-averse investors. The (HYLEX Quote)Morgan Stanley High-Yield Securities and (FHYPX Quote)Invesco High-Yield funds, for instance, both fell more than 10% in the third quarter and are off more than 40% over the past 12 months. Rising redemptions and default worries might point to even more trouble in this area, underscoring the idea that bonds can have plenty of risk, too.

The bottom line for fund investors is that the third quarter was an exclamation point on a lousy time since the Nasdaq's peak last March. But these are bizarre and emotional days, to put it mildly. Now is the time to balance your portfolio between value, growth and bond funds -- not cash out. This was always sound advice and that ugly statement in your mailbox makes it more so, not less.