How to ride the rebound
Here are four types of mutual funds that could recover fast in a stronger economy.
February 28, 2002: 6:00 p.m. ET
By Staff Writer Martine Costello
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NEW YORK (CNN/Money) - News that the economy grew faster than expected in the fourth quarter could inject some life into beaten-down mutual fund categories.
The situation for funds has been so bleak that the industry barely has a pulse. Funds suffered their worst performance in 30 years in 2001, and this year hasn't been much better. Only such niche players as gold funds and short sellers have made any decent money at all.
Even value funds have had a tough time, with mid-cap and small-cap funds barely breaking even. And gloomy outlooks for some big tech stocks gave the Nasdaq composite its worst monthly loss since September.
Still, if you think the economy is on the rebound after upbeat reports on the economy, consumer spending and personal income, here are some ways to ride the recovery.
Growth gets a shot in the arm
The first place to look for a turnaround probably will be in funds that buy growth stocks, since a stronger economy means better corporate earnings, said Jeff Tjornehoj, a Lipper research analyst. "That's why value funds have been strong in the past two years: When earnings decline, growth gets hammered."
Large-cap growth funds are down nearly 20 percent in the past 12 months, according to Morningstar. Mid-cap growth funds lost nearly 19 percent, while small-cap growth funds lost nearly 9 percent.
But don't expect the go-go growth of the late 1990s, Tjornehoj cautioned, and don't be surprised if you have to wait until the third quarter. It may take time for the turnaround to materialize.
"There is so much stimulus sloshing around in the economy, it's bound to take hold," Tjornehoj said. He expects growth stocks to deliver about 7 percent in the last six months of the year, compared to about 3 to 4 percent for value.
Some growth funds to consider: Check out the MONEY 100 list of funds, which includes such names as Smith Barney Aggressive Growth and T. Rowe Price Mid-Cap Growth.
Tech funds come out of the cold
Elsewhere in the growth universe, tech funds have fared even worse during the past year, hemorrhaging nearly 35 percent, Morningstar said.
But the sector could benefit as companies, bolstered by a stronger economy, start spending again, said Bob Turner, chief investment officer at Turner Funds, a family of more than 20 mutual funds that specializes in tech and growth stocks.
For example, companies such as Procter & Gamble (PG: up $2.76 to $87.55, Research, Estimates) and GE (GE: up $0.95 to $39.45, Research, Estimates) understand that the only way to improve profits is to improve productivity -- through technology, Turner said.
Turner Funds is focusing on tech names that are leaders in fast-growing segments and are gaining market share, including Cisco Systems (CSCO: up $0.73 to $15.00, Research, Estimates), Turner said. Another favorite is Marvell Technology (MRVL: up $4.70 to $35.39, Research, Estimates), a chip maker in high-speed networks.
The economic turnaround will lead to a ripple effect in tech, Turner said. Procter & Gamble needs an effective, high-speed network so its business units can properly communicate, so it buys from Cisco; Cisco in turn buys chips from Marvell; and so on.
If you want to play the sector but are afraid of the short-term volatility, try funds with solid long-term records that spread their bets. Two good options include Icon Information Technology and Seligman Global Telecommunications.
Small caps may deliver big returns
History has also shown that small caps lead the way out of a recession, said Dan Perkins, manager at Perkins Opportunity, a small-cap fund, and Perkins Discovery, a micro-cap offering.
In fact, since World War II, small caps have outdone large caps in eight out of nine recessions.
The story with small-cap stocks has been mixed. Small value has been one of the few winners during the two-year bear market. The category is up about 13.7 percent in the past 12 months, Morningstar said. Small blend funds, which invest in growth and value stocks, are up nearly 7 percent. But small growth funds are down 8.1 percent.
Perkins said holdings such as Datakey have performed well after the Sept. 11 tragedy -- and he believes they will be part of the rebound.
Datakey (DKEY: down $0.15 to $4.55, Research, Estimates) makes a "smart card" for Internet security for banks, government offices and other operations that need high-level safeguards.
GDP helps junk
On the fixed income side, bond funds could be hurt by a stronger economy, since the Fed is more likely to raise interest rates and investors will naturally gravitate to stocks.
But one bond category that could benefit from a strengthening economy is High-yield. High-yield funds, also known as junk bond funds, invest in risky corporate debt. It's risky because it's below investment grade, which means it's not as solid of an investment as a U.S. Treasury, for example. Because they take on more risk, they can earn higher returns.
The problem with high yield is that growing companies may not always be able to pay back the debt. They take a chance on a big expansion, for example, but it may not pan out. Then, they'll default on the loan, in the same way you might default on your mortgage.
A strong economy will lower corporate default rates on debt and give high-yield a boost, said Tom Price, manager of Strong High Yield.
"You need a strong economy for highly-levered companies to make it," Price said.
Defaults on corporate debt typically are higher in a bad economic climate. The default rate in 2001 was 9.8 percent, the highest in a decade. That figure is likely to fall in a strengthening economy, Price said.
High yield funds are the only fixed-income category that lost money in the past 12 months, down nearly 6 percent, Morningstar said. But the sector is also more tightly linked to the economy and the stock market than any other bond category.
What should you do?
Of course, a sign that the economy is coming out of the dumps doesn't mean the average investor should make drastic changes.
The best strategy for a volatile stock market is to keep your bets spread among different asset classes, including small-, mid- and large-cap stocks, growth and value companies, as well as international stocks and bonds. (Click here to use CNN/Money's asset allocator calculator.)
But the trick to a great asset allocation plan is to occasionally rebalance your mix -- trimming from winners and adding a little more to areas of the portfolio that have been under water. So now may be the time to tweak it by putting more money into sectors that are poised for a pop. 
* Disclaimer
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