A fourth-quarter rally saved the year for mutual funds.

It was a year that started with much hope and promise, yet seemed poised to end in bitter disappointment-until a memorable late rally made everything right again.
    Who could have predicted the Boston Red Sox and the stock market would travel on parallel paths in 2004?

Absolutely nobody. But that's the way it went last year in the world of equities and, by extension, mutual funds. It was a year full of surprises, some of which analysts are still scratching their heads over.
    Forget predictions, trends and momentum. Trying to predict the stock market of 2004 would have been like forecasting the end to the Curse of the Bambino. "It was two different years," is how Steve Falci, chief investment officer of equities at Calvert Funds, summed up what happened.
    If the equity and fund story of 2004 was indeed a two-part story, it's safe to say that investors would prefer to forget the opening act that encompassed the year's first three quarters. If asked to remember what it was like at the end of September, they'd probably cite two things: an S&P 500 Index with growth under 2% for the year and an overwhelming feeling of uncertainty. The heated presidential election was in full swing, with polls offering no clue of who would eventually win. Iraq remained a hotbed of violence. Oil prices were going up, the value of the dollar was going down.
    The Fed was on mission to raise interest rates, it was clear, but anticipation grew about how fast and by how much. Then, as the presidential election approached, things began to turn. Oil prices stabilized somewhat, and Republicans won convincing victories in national elections that didn't require the U.S. Supreme Court intervention many feared. In the months that followed, the stock market bounced back, with investors seemingly regaining some vigor and confidence. The S&P 500 finished with a gain of 8.99%. That could have been viewed as disappointing after the 26% rebound it gave investors in 2003, but after suffering through the adversity of 2004, investors were largely happy.
    "I guess it's fair to say the final quarter ultimately is what most people will remember," says Kunal Kapoor, an analyst with Morningstar. "I think we had a remarkably choppy market most of the year and strong gains to finish out the year."
    Just as surprising as the rally that happened in the fourth quarter were the dynamics behind it. Few could have predicted that small and mid-caps would lead the way, with large caps once again in the doldrums, and that value style funds would trounce their growth counterparts. By the end of 2003, the prevailing opinion was that the multiyear small-cap rally had run its course, that changes in valuations had both large-cap and growth funds poised to assert themselves in 2005.

It turned out to be a false premonition. Even REITs, which some were expecting to run out of steam two years ago, finished at the top of the heap. Throw in the strong performance by natural resources-which were helped by the spike in oil prices-and what you had was an unpredictable rally led by an unpredictable cast of characters.
    "I think that people were sort of surprised that for the fourth year running, small and mid cap beat large cap, in some cases by a lot," says Andrew Clark, senior research analyst at Lipper Inc. "That sort of startled people because the feeling was, toward the end of 2003, that was going to reverse."
    The poor performance of growth caught many managers by surprise because, as 2003 ended, the economic recovery was two years old and the stock market was coming off a banner year. "It seemed to be about that time for growth to step forward and do well," he says.
    Instead, it turned out that investors were "licking their wounds in 2004 for the most part," Clark says. Overall caution in the investment community hurt growth managers, as did a slow capital expenditure recovery and miniscule growth in real wages, he adds.

Small caps, meanwhile, were still benefiting from the momentum of 2003 and, by and large, were simply performing better. "It was another year where small-cap earnings were better than large-cap earnings," Clark says.

    As frustrated value investors learned in the late 1990s when they lagged their growth rivals for half a decade, it is remarkable how long a trend can remain your enemy or your friend. It was the fifth year in a row that value beat growth funds, notes Ernie Ankrim, chief investment strategist with the Russell Investment Group. It also marked a year in which income-oriented stocks like utilities and REITs outperformed the general market, he says. Small caps were perhaps the most startling performer, he says, and are on a five-year run in which they have outperformed large caps.
    Since January 2000, Ankrim notes, the Russell 2000 has brought an annualized return of 6.6%, compared with an annualized loss of 1.8% for the Russell 1000. It's a run that came after a 17-year drought in small caps. "The five years leading up to 2000, the sector was as bad as you could find," he says. "At some point the prices got too low and you couldn't ignore them anymore."
    The small value sector, comprising 318 funds and $81.2 billion in assets, finished the year with a gain of 20.58%, according to Morningstar. Small growth, with 768 funds and $131 billion in assets, gained 12.09%.
    Mid-caps were close behind, with mid-cap value finishing at 17.90% and mid-cap growth at 12.93%. Large-cap value gained 12.91% and large-cap growth, with 1,457 funds and $620 billion in assets, brought 7.64%. The largest category, large-cap blend, with 1,625 funds and $858 billion in assets, finished at 9.96%.
    The Winslow Green Growth Fund, a small- and mid-cap fund, experienced a volatile year that mirrored the general market. Matt Patsky, a fund co-manager, recalls a painful July during which the fund lost 10%. "The third quarter was the worst," he says.

The fund rebounded in the fourth quarter, finishing the year up more than 12%, following a 2003 in which it gained more than 90%. "I think we were pleased with how it turned out, all things considered, and I feel comfortable about our positioning for 2005," he says.

The fund's bottom-up stock-picking style turned out to be well suited for a market that, except for limited opportunities in natural resources, offered little in the way of winning sector plays.
    The funds two top performers, for example, were an entertainment company and a company the fund picked off the dot.com trash heap. Lions Gate Entertainment Corp. was the fund's top performer, more than doubling in value during 2004, finishing the year at about $10 per share. The fund bought the stock because of its large library of historic films, its use of syndication strategies to leverage risk on its film projects and its rational management philosophy, Patsky says. The other standout was Aptimus Inc., which provides networking technologies for Internet advertisers. The fund bought the company at about $11 per share in the spring, and saw it rise to about $25 at the end of the year. Aptimus, whose competitors include companies such as DoubleClick, was one of the many riches-to-rags companies of the Internet bubble explosion several years ago. Yet the fund felt smart cost cutting by management had the company well positioned for a recovery.
    International equities also outperformed the general market last year, and managers in this sector say they are detecting increased interest from diversification-seeking investors. "It seems to me that the weaker dollar was the trigger to get people to look into international investments," says Soeren Rytoft, an investment strategist with Metzler/Payden Investment Advisors, with home offices in Los Angeles and Frankfurt. "There was also a lot of understanding among investors about the need for a diversified portfolio."
    The firm's European Emerging Markets Fund finished the year with a gain of 53% in 2004, benefiting from higher oil prices and economic growth in Eastern Europe, where most of its holdings are based. About 45% of the funds holdings consist of companies in Russia and Poland, Rytoft says. The best performers last year were Lukoil, Russia's second largest oil company, and Bank Pekao, a diversified financial services company in Poland. "We see this as one of the best developing regions five to ten years from now," he says.
    As for the immediate future, analysts continue to watch the large-cap and growth sectors and speculate as to whether valuations have reached the point where they become an irresistible play for investors. "I certainly think larger caps are sooner or later going to start to look a bit better," says Kapoor of Morningstar.
    Ankrim of Russell Investment feels there's a chance that large-cap companies will try to get the attention of investors by increasing dividend payouts. As in 2004, some analysts feel that changes in the dividend tax law will work to the benefit of the large-cap sector. "We will start to see equities compete on a yield basis," he says.
    Yet there are also those who feel the small-cap run has a ways to go. Patsky says that in the post-Enron era, the investor confidence in large-cap price stability isn't as strong as it used to be. "There has been a historical perception of there being more stability in large caps and a willingness to pay a premium for their earnings streams that more and more people have called into question," he says. "It's become clear that there is risk across all market caps."