(MONEY Magazine) – As bill clinton might put it, we feel your pain. after all, 1994 delivered a George Foreman-like pounding to most fund investors' portfolios. Wham! The Federal Reserve Board hikes interest rates an astonishing six times in 10 months, rocking stock and bond funds. Bam! Derivative issues unravel like dime-store socks, steepening losses. Pow! Mexico, the blue chip country of Latin America, unexpectedly devalues the peso, sending many international funds (and even some seemingly all-American entries) tumbling. "It was a year of constant headaches for fund investors," says John Rekenthaler, editor of Morningstar Mutual Funds, a Chicago-based investment publication. "There was one unpleasant surprise after another."

How severe was the battering? As the table on the opposite page shows, all 14 fund categories tracked for Money by Morningstar Inc. lost money last year. Foreign regional funds were the biggest tankers of all, sinking 6.7%. U.S. equity portfolios proved no refuge, with the average domestic-stock fund dropping 2%, well below the 1.3% total return of the S&P 500-stock index. And taxable bonds fell 3.6%. As you will see in Money's comprehensive mutual fund tables, starting on page 82, the damage was widespread; of the 2,688 funds we track, only 406 stock funds and 101 bond funds turned in winning results for 1994. To help you find these hardy survivors in our listings, we denote them with stars after their names.

Don't let the gloomy numbers get you down, though. The worst is over, say many analysts. Money's chief investment strategist Michael Sivy predicts the S&P 500 will return a solid 10% this year. And looking ahead, the Dow could soar to 5000 by the end of the decade. The Fed is likely to continue lifting rates in 1995's first half, causing further setbacks for bonds. But by summer, long-term rates are likely to peak at 8.5%, and bonds figure to deliver total returns of about 8% in '95.

But back to '94 for a moment--and a good riddance glimpse at why no investing strategy seemed to work:

Interest rates rose and rose and rose. Starting with the Federal Reserve Board's first interest-rate hike in February, the dispiriting tone of 1994 was set. By year's end, 30-year Treasury bond yields had climbed to 7.9% (from 6.4% in January), and prices on long-term bond funds were off 4.2%. Intermediate-term funds fell 3.7%, and even relatively safe short-term portfolios took a 0.7% hit.

The Fed's moves slammed the stock market as well, as investors were simultaneously tempted by rising fixed-income yields and worried that higher rates would slow the economy and slice corporate profits. The worst performing diversified equity fund: $57 million American Heritage, an aggressive growth fund that tumbled a heart-stopping 35.3% mainly because of its heavy stakes in four skidding small stocks, including Spectrum Information Technologies.

Derivatives deepened the damage. Many fixed-income managers used these slippery instruments, whose value is tied to or derived from an underlying asset or index, to make hefty bets that rates would continue to fall. When rates swooshed up instead, many derivative securities swooned. Among the most notorious fund disasters was $565 million Piper Jaffray Institutional Government Income, which plummeted 29% as its huge derivatives stake cratered. Derivatives also played havoc in the normally sleepy money-market arena, where one tiny institutional fund, $84 million Community Bankers U.S. Government, became the first money fund in more than a decade to break the buck-that is, see its net asset value fall below $1 per share. At least 16 fund sponsors were forced to bail out selected retail portfolios to avoid similar catastrophes. And in the muni market, already mangled by rising rates, tax-exempt bond prices were further mauled by December's news that an Orange County, Calif. investment fund had lost an estimated $2 billion from highly leveraged speculation in derivatives. California single-state muni funds, which naturally had the largest exposure to Orange County issues, ended the year with a painful 7% average loss.

The Mexican peso devaluation KO'd international stock and bond funds. Late December's 31% peso plunge was the coup de grace in a rocky 12 months for international equity portfolios, which had already toughed out a 30% drop in the Hong Kong market earlier in the year. All told, foreign-stock portfolios gave up an average 2.5%. Funds that focused exclusively on Latin America stocks, however, suffered even bigger losses. For example, $445 million TCW/DW Latin American Growth plunged 23.7% and $616 Fidelity Latin America lost 23.2%. International bond portfolios were also hard hit; on average, they slid 4.2%. And that number masked a few Titanic-size wrecks, such as the peso-propelled 30.8% drop in $1.6 billion Alliance North American Government Income B.

The peso claimed some unexpected victims as well. For example, $11.1 billion Fidelity Asset Manager lost 6.6% for the year, compared with a 2.7% drop for the average equity total-return fund, because of its 7% exposure to Mexico. And even some domestic bond funds turned out to have peso-denominated holdings. Examples: $1.5 billion Fidelity Short-term Bond's 6% Mexican stake contributed to its loss of 2.2% in the fourth quarter; and $2.3 billion Scudder Short-term Bond lost 1.6% in the fourth quarter, hurt by a 5% stake in Mexican debt.

Despite the many market crises, a few nimble funds did manage to make money last year. Indeed, stock portfolios that focused on the handful of sizzling sectors--technology, health care and Japan--even posted double-digit gains. Leading the pack was $251 million Seligman Communications & Information A, up a lofty 35.3%. Among diversified equity funds, the top performer was $67 million Govett Smaller Companies, up 28.7% on the strength of its technology and Japanese stockholdings. In the fixed-income category, the prime mover was $8.6 million Fidelity Deutsche Mark Performance, which gained 16.4% on its holdings of German debt and currency. Among domestic portfolios, many that focused on the shortest maturities and avoided risky derivatives posted profits; $71 million Hotchkis & Wiley Low Duration was the best, up 5.2%.

Unfortunately, in addition to the first truly unsettling, across-the-board investment bummer in 20 years, fundholders were further vexed in 1994 by several major confidence-rattling industry tremors. The year started with the firing by Denver's $10 billion Invesco group of former star manager John Kaweske for violating the company's code of ethics. Other controversies included an SEC settlement in which Milwaukee's Strong/Corneliuson Capital Management reimbursed $440,000 to three of its mutual funds to settle charges that it hadn't followed proper pricing procedures in moving securities from one fund to another (Strong neither admitted nor denied wrongdoing). And industry giant Fidelity Investments committed two embarrassing bloopers. In June, a computer snafu led an employee to report day-old prices on 166 of its 210 funds. In December, the company announced that the flagship $36.7 billion Magellan fund would not make a year-end distribution of capital gains and income, contrary to previous estimates of a $4.32 per share payout. The company later explained that the mistaken estimate occurred after an accountant dropped a minus sign in a computation.

Clearly, the lesson of '94 is that, now more than ever, it pays to choose your portfolio carefully and to keep close tabs on its performance. That's where Money's comprehensive year-end guide to funds can help. Starting on page 76, we give you an X-ray analysis of the best-performing individual funds in six major categories for the past year, three years and five years. In the next section, we offer results of 2,688 funds broken into two groups: major funds and single-state muni funds. The major category includes 2,125 stock and bond funds--our most comprehensive listing ever--that are open to all retail investors in most states for an initial investment of $25,000 or less. This year we also include figures to help you gauge each fund's after-tax return and potential capital-gains liability. Tax-conscious investors will also want to check out our guide to 563 single-state muni bond portfolios, which follows on page 114. You will find funds specializing in the tax-free bonds of 42 states and Puerto Rico.

As always, the best way to achieve long-term gains is to diversify, spreading your money among several different types of funds. And review all your fundholdings at least once a year to ensure that the manager--and your fund company--are living up to their promises. That's an essential strategy in any year.

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