Value funds, international equities and REITs remained strong last year.

    To get a feel for what happened in the mutual fund market in 2006, you could look at the S&P 500 and the respectable 15.8% return it gave investors, or at the way value funds once again outperformed growth funds, marking the sixth time in the past seven years that has happened.
    Investors could also take note of the unflappable real estate investment market, which despite a housing price collapse continued to chug along at a robust pace, or the ETF market, which along with the rise of fundamental indexing and lifecycle funds, is gradually making what could be profound changes to the investment landscape.
    But international funds, particularly those focused on emerging markets and real estate, were the performance kings in 2006, outperforming domestic funds for the fourth year in a row. In a market where leading sectors are always in rotation, that alone wasn't remarkable.
    But what took some people by surprise was the gusto with which investors were willing to pour their dollars into markets such as China, India and Latin America. Jeff Auxier, manager of the Auxier Focus Fund, notes that international funds drew so much interest last year that U.S. investors put the least amount of money into domestic funds since 1989.
    The run in international investments could remain strong in 2007 judging by the way fund managers are using international holdings, or at least domestic companies with global reach, to hedge against a possible slowdown in the U.S. economy this year. "A lot of this is because money flows have been so easy," Auxier says of the emerging market economies. "You have really had easy money globally, with unprecedented borrowing, that has just fueled all this."

Overall, A Good Year
    Perhaps the most surprising aspect of the mutual fund market in 2006 was how few surprises there really were, says Christine Benz, Morningstar's director of mutual fund analysis. Investment strategies that worked in 2005 more often than not worked out just as well, or even better, in 2006.
    "The fact that it was more of the 'same old, same old' was extremely surprising to me and other watchers," Benz says. "For example, the much ballyhooed rotation into large-cap growth never materialized."
    Even still, just about every sector gained in 2006, except for bear market funds, which collectively were down about 9%. Large-cap growth funds managed to gain 6.94% for the year and taxable bond funds were up 4.92%.
    "It was generally a very good year no matter where you were," Benz says. "It was a bad year to bet against stocks and bonds, even though there had been a lot of chatter that investors should temper expectations for stocks."
    Among the domestic fund categories tracked by Morningstar, real estate topped the performance chart with 344 funds, totaling $79.2 billion in assets, providing investors with a return of 33.83% in 2006. It was the continuation of a remarkable run in real estate, which has produced a five-year annualized return of 23.11%-the most of any fund category tracked by Morningstar except for diversified emerging markets, which tops the list at 25.99%.
    Small-cap funds of all types also stood out, with small-cap value funds returning 16.32% in 2006, followed by small-cap blend funds at 15.32% and small-cap growth at 10.50%. Among mid-caps, value funds were the leader with a 15.9% return, followed by blend at 13.87% and growth at 9.03%.
    Large-cap value funds continued their run of out performance, gaining 18.17% in 2006, compared with 14.10% for large-cap blend funds and 6.94% for large-cap growth. The wait for mega-cap growth stocks to take off is getting so old that basic definitions are being subjected to serious questions.
    It was performance that defied analyst predictions going into 2006 that, because growth stocks had become so cheap, a rotation from value to growth was just about due. While that rotation didn't take place, the valuations did lead to another phenomenon: value managers investing in traditional growth stocks.
    "We are hearing from many managers who are buying one-time growth stocks," Benz says. Traditional growth sectors that are appearing frequently in the portfolios of value managers include health care and technology, she says. "Even the blue chip stocks, like Dell and Microsoft, have been heavily owned among value managers."
    The domestic market in 2006 greatly benefited from healthy corporate earnings in 2006, says David Reilly, director of portfolio strategies with Rydex Investments. "The real fuel for the market domestically has been this fantastic growth rate in corporate earnings," Reilly says.
    The pace, however, may slow down in 2007 if the economy, as many expect, continues to cools off. "We are not forecasting a big-time bearish quarter, but we think the market may pull back a little bit," Reilly continues.
    Many domestic fund managers have the same forward view and, as a result, have been buying up companies with strong global reach-an attempt to ride out a domestic slowdown by latching onto international economic growth.
    This isn't surprising considering the performance of international funds last year. Overall, the 2,648 international funds tracked by Morningstar brought an average return of 27.07% for investors in 2006. The leading performers were Pacific/Asia funds (minus Japan), which gained 45.84% and 19 funds that specialized in Latin America, which averaged a 44.34% return last year. European stock funds brought a return of 33.58% and emerging markets funds-comprised of 251 funds with $103.65 billion in assets-generated a 32.45% return.
    With four years of outperformance under its belt, the international market is starting to leave an imprint on the U.S. investing community. International fund launches are picking up pace and, although there was a slight shift back to domestic funds late in the year, investors were growing more inclined last year to pick international funds over domestic.
    Martin Jansen, senior portfolio manager at ING Investment Management, notes international holdings have been taking up a larger share of both individual and institutional portfolios. While the typical institutional investor might have had 10% of its assets in global and international holdings in 2000, it's more typical nowadays to see 30%. "It seems that investors are waking up to the idea that if you are looking at investing, there are a large number of opportunities in the world, and they are not necessarily all in the U.S.," Jansen says.
    The enthusiasm in the international investing market has reached a level where market watchers are concerned about valuation bubbles, return chasing and an overall atmosphere of "irrational exuberance." This is particularly true in emerging markets, where analysts fear investors may be disregarding inherent risks of investing in developing economies.
    Jansen, for example, points out that the Chinese domestic index rose a startling 40% in December alone. "Even though we're optimistic about China over the long term, that's a bit scary," he says. "It seems too much like a bubble."
    Auxier of the Auxier Focus Fund adds that any tightening of the global money supply there could bring a swift change of course in emerging market performance, possibly blindsiding many investors. "A lot of this is driven by unprecedented easy money conditions," he says. "Unfortunately, the margin for safety isn't there."

A Changing Landscape
    Last year saw continued growth in the ETF market, to the point where there is little doubt they now accompany traditional mutual funds as a key building block of today's investment portfolios. The combined assets of the nation's ETFs rose to $396.73 billion as of November, according to the Investment Company Institute. That was a 37.3% increase from a year earlier. There were a total of 244 total domestic ETFs in November, up from 146 in December 2005.
    The number of ETFs is expected to continue growing in 2007, as companies continue to find ways to slice up the market into individual indexed sectors. In one example, X Shares Advisors LLC recently announced it will launch ETFs that are indexed to the economies of 21 states, including California, which it notes has an economy that rivals those of Russia and Brazil.
    ETF activity may also get a boost as the Securities and Exchange Commission considers proposals to speed up the ETF approval process. "It's ETF after ETF and they're cutting the sectors ever more narrowly," says Benz of Morningstar. "Advisors have really embraced the ETF."
    The competition from ETFs may already be taking its toll on mutual fund companies, she says. Smaller fund companies are in some cases struggling, and consolidation and acquisition activity within the industry is expected to continue in 2007. Whether this is a direct symptom of ETFs gobbling up more investment dollars is unclear, Benz says, "but investors are sending fewer assets to fewer firms."
    Another aspect of ETFs that deserves scrutiny from investors is whether or not they are passive index funds. Some ETFs have gotten so specialized in their focus that it could be argued they are actively managed. "It could be argued they are running a version of an active strategy by actively managing their benchmarks," she says. "There is definitely a blurring of the lines between active and passive."
    Another area that stirred controversy in 2006, and can be expected to continue to do so in 2007, is the introduction of fundamental indexing into the mutual fund and ETF market place. PowerShares introduced a fundamental index ETF on the New York Stock Exchange last year, based on the work of Robert Arnott, chairman of Research Affiliates.
    Arnott's index, and competing versions that have been introduced, work on the premise that traditional market-cap-weighted indexes are biased towards overvalued companies. Fundamental indexes throw out the cap weighting and put a new spin on the weightings. Research Affiliates, for example, weights companies by a number of factors that include a company's book value, income and dividends.
    Benz of Morningstar says one aspect of the fundamental indexing controversy is whether or not traditional cap weighting is inherently flawed, or just going through a period of underperformance because small-cap stocks are in favor. "Should the megacaps take off, the fundamental indexes may be hard pressed to beat an S&P Index," she says.

Growth Versus Value-Again
    The analysts were wrong again in 2006 when they predicted a rotation into growth stocks, which is why many are hesitant about making the same prediction in 2007.
    Part of the problem with growth funds is that people still equate technology with growth, says Alex Motola, manager of the Thornburg Core Growth Fund. "People haven't been comfortable with growth stock investing since the Internet bubble," he says.
    Perceptions still need to catch up to the reality that growth stocks encompass a broad swath of industries, many of which are experiencing healthy earnings growth, he says. Motola's best-performing stocks in 2006 were, as he described it, a "pretty eclectic" mix that included contributions from a number of different sectors. One such company was Las Vegas Sands Corp., whose share price has more than doubled over the past year. Thornburg bought the stock in late 2005, partly because of the company's aggressive movement into Macau, China's lone gambling center. "They are basically replicating the Las Vegas strip down there," he says.
    Another fund holding, DirecTV, nearly doubled its share price last year on better-than-expected earnings and merger speculation. Although the company is in a highly competitive sector, with pressure from cable television companies that are bundling TV, Internet and phone services, Motola feels the satellite TV company will benefit from its program offerings and national reach. "The economics for building out such a big footprint are much better than for a regional TV company," he says.
    Thematic investing was a chore in 2006, managers say, as there were few strong themes that investors could carry through the year. Yet some funds were able to find niches of activity that yielded good results.
    At Aston/Optimum Mid-Cap Fund, a fund that uses a blend of growth and value stocks, manager Thyra Zerhusen focused on the business-to-business market. "We like companies that make their clients more productive," Zerhusen says.
    One such company was BorgWarner Inc., a manufacturer of vehicle engine components that acts as a supplier to companies throughout the world.     The fund has held the company for four years, during which the share price has about doubled.
    The fund uses a mix of strategies to generate alpha, Zerhusen says. In an example of a value play last year, the fund bought Lexmark International Inc., a maker of computer printers, at a time when its share price was taking a beating over sagging profits. Aston/Optimum bought it after concluding the company would benefit from focusing on the business market. The strategy worked, as the share price rose from about $45 to $74 last year. The fund is also buying traditional print media companies, such as The New York Times and Gannett, which have been losing advertising dollars to the Internet and other new media. It's a sector that's been abandoned by even some value managers, but Zerhusen feels all that's needed in the sector is a shift in focus. "There is so much negative perception, the reality is not as bad as people think it is," she says.