Which Funds Survived the Third Quarter Roller Coaster?

by: Libby Mihalka, CFA

The Third Quarter was another roller coaster ride that almost defied gravity on the downside and upside. The average general domestic stock fund was up 1.2 percent, according to Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.
International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions.

A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).

Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares (NYSEARCA:IVV) generated 3.1% third quarter while the S&P400 MidCaps (NYSEARCA:IJH) and the S&P600 SmallCap ishares (NYSEARCA:IJR) fell. International large caps also outperformed international small caps this quarter for the first time in years.

Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares (NYSEARCA:IVW) were up 5% for the quarter while the S&P500 Value ishares (NYSEARCA:IVE) gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares holding their value.
The re-introduction of risk was very apparent in the bond market, with high quality bonds rising in value and low quality falling. Scared by the upheaval in the credit markets, investors began piling into high-quality bonds, drove the Lehman Brothers Aggregate Bond Index (NYSEARCA:BND) up 2.8%, and caused yields to fall. For example, the yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries (flight to quality) also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated (junk) corporate bonds, to post a modest 0.12% loss for the quarter.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.

Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index (NYSEARCA:DJP-OLD) rose a more modest 6% during the quarter and 10% for the year.Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.