It was a rough ride for equity mutual funds this year, as anyone who paid the slightest attention to the stock exchanges knows. The Dow seemed to dip as often as it climbed.
"Equity-only funds have not done well," says Jeff Tjornehoj, the head of Lipper Americas Research (in an understatement). In his September market performance Web address, Tjornehoj described the year's long and short equity fund strategies as "disappointing," noting that investors in most of them could probably have done as well in bond funds.
Lipper's Tom Roseen reported in his 2011 third-quarter equity mutual fund performance review that equity funds had lost 17.44%, suffering their worst declines since the fourth quarter of 2008. Only two of Lipper's 86 equity fund classifications in the third quarter posted positive returns: dedicated short-bias funds (up 29.82%) and commodities specialty funds (up 1.17%). World equity funds fell 20.44% for the quarter, while mixed equity funds fell 10.08%, sector equity funds fell 15.36%, and U.S. diversified equity funds fell 16.67%.
Few of Morningstar's top ten equity funds ranked by three-year returns had reached even 4% last year as of December 9. The only one was Direxion Funds' aggressive Monthly Nasdaq-100 Bull 2x Fund, which reached 7%, a far cry from its 14.75% showing in 2010.
The Direxion fund aims to double the performance of the Nasdaq-100 every month, which portfolio manager Paul Brigandi achieves through leverage. If there is $10 million in the Nasdaq-100, Brigandi buys derivatives on the index, mainly total return swaps and futures, totaling $20 million, essentially doubling his bet so the fund's investment can return twice the index. Traders use the fund, says Brigandi, because "they have a strong opinion of the index and want to magnify returns over a short period of time. They have a particular view of the market over one, two or three days, maybe a week or two weeks."
With a minimum investment of $25,000 and an expense ratio of almost two points, which may not include costs associated with derivatives positions such as collateral and margin, these bets are for investors who are up for taking on considerable costs and risk.
In some years, it's best to look forward. Toward that rosy prospect, Fidelity Investments has studied ten sectors and found 30 equity investment themes, which it explores in a research report titled, "Equity Sectors: Investment Themes for 2012 and Beyond."
John Harris, Fidelity's consumer sector leader and portfolio manager of the Fidelity Select Consumer Discretionary Portfolio, has examined consumer discretionary spending and arrived at three conclusions: First, emerging middle classes in China, Brazil and India will give a boost to consumer luxury goods such as high-end jewelry, handbags and accessories. Second, sentiment will rise among high-income consumers in the U.S. and Europe as financial positions improve and the recession eases. And third, the Internet will prove disruptive to some industries and fortunate for others.
Harris points to figures showing same-store sales growth among high-end retailers has increased year to date by 6.1% while mid- to lower-price retailers have seen growth of only 3.7%. "Roughly one billion emerging market consumers are projected to join the middle class by 2020," says Harris, whose research also found that 70% of Chinese consumers saw luxury brands as "a way to demonstrate their status and success."
He expects Internet buying to grow quickly and retailers with the best "multichannel" distribution capabilities to prevail over competition. The leisure industry, including the travel industry, will experience disruptions in consumer demand as online travel sites aggregate data and shift consumers to better deals. Overall, Harris' luxury company picks may include makers of "lifestyle brands"; the cruise industry, which he expects to become more Internet accessible; the Asian gaming industry; high-end automobiles; and shoes.
Another sector Fidelity has got its eye on is utilities. As the diviner of what's ahead for this area, Douglas Simmons, who manages the Fidelity Select Utilities Portfolio, says his outlook doesn't depend much on the economy as a whole improving.
"If we're going into a lower GDP growth environment where we have lower interest rates, I think growth is going to become harder and harder to come by, and growth is going to become more and more important as a component of returns," he says. "My view is that yield is likely to become a more important component of returns and that investors will be focused on yield. And utilities are one of the highest-yielding sectors of the S&P. It's quality yield, predictable and sustainable yield."
Simmons says the future of energy, specifically, would be affected by smaller coal-burning plants. These smoke-belchers are the least likely to be retrofitted to meet new standards from the Environmental Protection Agency demanding that coal- and oil-burning plants upgrade their facilities or be shut down. EPA commissioner Lisa Jackson has given the plants four years to meet these standards. Smaller plants would "be the most uneconomic to retrofit, with natural gas prices as low as they are," says Simmons, and unlikely candidates for investment. Simmons estimates they would make up 4% to 5% of the U.S. gas-generation fleet and the loss of their 40,000 to 50,000 megawatts of power-generating capacity in the U.S. would raise energy rates and therefore the stock of the remaining plants and suppliers, hiking the value of their shares.
Simmons is also watching the logistics and delivery end of the natural gas business, looking to invest in new pipelines and companies bringing new supplies to market. Even if environmentalists win and shale supplies are curtailed because of controversy over fracking, Simmons says, "The whole utilities industry would benefit from restrained natural gas supplies leading to higher power and NG prices. Some utilities are in a win-win situation."
Some investors might pass over the industrials category entirely, equating it with urban decay and towering smoke stacks. But before they do, they may want to pay close attention to what portfolio analyst Tobias Welo has to say about the sector. Much of the modern regulation that was said to have killed off American industry has today actually been aiding companies that are compliant with it. "Drivers of energy efficiency continue to be positive," says Welo, manager of the Fidelity Select Industrials Fund. Many companies are already seeing their investments in energy-saving technologies pay them back in three to five years. The U.S. Energy Information Agency projects that such adoption could mean an 8%-13% reduction in per capita commercial energy consumption, he says.
American industry will also gain from the massive infrastructure work waiting to be done in the U.S., including roadwork, bridge-building, schools, rail transit, levees, aviation systems and power grids. The American Society of Civil Engineers estimates it will cost $2.2 trillion and take more than five years. As Welo points out, China, which has excelled at building cranes, ships, construction equipment and power distribution, can't easily penetrate the barriers to entry in the United States and Europe, where supplier networks have been entrenched for 50 years (much longer than the 10 to 20 years they've existed in the BRIC countries). This goes for large agricultural equipment, too, adds Welo.
This is not to say Welo is dismissing the Chinese competitive threat. Among other things, the country has long-range efforts to build its own planes. It's in the very early days of a "decade-plus" plan to build the C919 plane, he says. However, that plan has been hung up on intellectual property rights. Two Chinese government-owned and controlled entities have been asking for competitive bids from U.S. companies to do work on the aircraft, but the Chinese government also wants to own those vendors' intellectual property as part of the deal. In return, the Chinese government companies will offer a large volume of work.
Welo thinks that smart U.S. vendors will take the deal and give up the intellectual property, since they are likely working on new generations of the technology anyway.
"The U.S. company's rationale is, 'If I supply this now, by the time they produce the second generation, I'll be working on the fourth or fifth level," Welo says.