Real-Estate-Sector Funds
Post the Best Returns

The second quarter gave mutual-fund investors reason for cautious optimism after the first quarter's bumpy ride.

All diversified U.S. stock funds posted gains for the quarter ended June 30, with an average rise of 1.8%, according to investment research firm Morningstar Inc. in Chicago.

That is a reversal from the first quarter, when just about every diversified U.S. stock fund lost money. The S&P 500, meanwhile, was up 1.6% for the quarter.

Growth funds, which invest in stocks with fast-growing earnings, perked up after several years of dominance by value-oriented portfolios. Small growth funds led the growth category with an average return of 3.6%.

But the best returns of the quarter came from sector funds, which focus on stocks in a single category or geographic region. Housing bubble or no housing bubble, real-estate portfolios, which invest only in stocks related to real estate, such as real-estate investment trusts and home builders, topped the list. Real-estate funds jumped 13.1% in the quarter alone thanks mostly to the strong performance of REITs.

Every quarter, The Wall Street Journal highlights some of the best-performing mutual funds over the short term and longer term. We usually look at funds over the 12-month and three-year periods. But this time, to add some variety, we took a look at the 10-year time frame instead of the three-year period. The winners include a Latin America fund and a real-estate portfolio. The decade's champ, though, is a fund that invests only in the smallest of small stocks. All data come from Morningstar.

12-Month Winner

With a return of 63.07%, the Merrill Lynch Latin America Fund is the No. 1 fund in terms of total return for the 12 months through June 30. The fund has benefited from Latin America stocks' recent tear as evidenced by the 61% jump in the Morgan Stanley Capital International (MSCI) Latin America index over the past year.

Despite its impressive returns, the Merrill Lynch fund has a front load of 5.75%, along with an expense ratio of 1.85% that can eat into returns. So it is worth mentioning the No. 2 fund, the T. Rowe Price Latin America Fund, a no-load portfolio managed by Gonzalo Pangaro, with a 61.6% return and an expense ratio of 1.4%.

Despite two years of outsize gains, Latin America stocks still have plenty of room to run, says William Landers, 36 years old, manager of the Merrill Lynch Latin America portfolio. "If we were just going to look at earnings growth, we could easily see Latin America returning north of 20% to investors this year. So far...we think we're about halfway there."

Most of that growth will come from the region's largest country, Brazil, where Mr. Landers was born and raised. The fund is heavily concentrated in the country. "We're still excited about it because despite all those great returns, valuation is still very attractive. It's trading at a [price-to-earnings ratio] of 7.5 times 2005 earnings, with earnings growth north of 40%, so we don't think we're anywhere near being done."

Like most Latin America funds, Merrill Lynch Latin America, based in Princeton, N.J., has capitalized on improvements in the region. Companies there have improved cash-flow generation and corporate governance and have increased efforts to protect the rights of minority shareholders. In addition, Mr. Landers says, the new checks and balances are making Latin American companies less susceptible to the political changes that have affected investing in the region in the past. "I think you've seen a certain level of maturity come to these markets over the last presidential cycle in both Brazil and Mexico," says Mr. Landers. "You had perennial opposition parties taking over the presidency without any of the major political fallout or any economic crises."

Ninety-five percent of the fund's $200 million in assets is concentrated in Brazil, Mexico and Chile. The fund owns about 60 stocks, including top holding Petrobras Energia Participaciones SA, Brazil's oil and gas monopoly. The company should have more than 10% in production growth this year and even higher than that next year, Mr. Landers says. "It's hard to find a company of that size that's giving you that type of growth" and thanks to concerns over its government ownership, he says, it still trades at a huge discount to its global peers in developed and emerging markets. Petrobras is up 17% over the past 12 months.

Mr. Landers is keeping his eye on U.S. interest rates. Rising rates could spoil Latin America stocks' run.

"If the Fed were to raise rates quicker than it has, that would be a sell signal for these markets because investors tend to see emerging markets as a higher-risk area, and as rates go up they tend to bring money back to the U.S., or at least to developed markets." That said, he's sticking with his forecast of a 20% return for Latin American markets in dollar terms for 2005. "It's a very achievable place to get to," he says.

Five-Year Winner

"We don't think there's a [housing] bubble, [and] we don't think there's going to be a bust." That bold statement comes from Samuel Lieber, manager of the Alpine U.S. Real Estate Equity Fund, the best-performing mutual fund for the five-year period.

Mr. Lieber's confidence might be due to his background as a commercial real-estate broker, urban planner and real-estate stock analyst. He bought the fund-management contract in 1998 from Evergreen Investments and relaunched it under the Alpine banner.

The fund is up 34.4% a year over the past five years, compared with the 20.8% of its specialty real-estate peers.

Unlike most real-estate funds, which usually seek income from their investments, the Alpine fund focuses on capital appreciation first. "That gives us a greater flexibility in investing at different points in the real-estate cycle," the 48-year-old manager says.

Though Mr. Lieber is confident there is no housing bubble, he acknowledges that a few housing markets are "overheated," particularly the Miami condo market. His reasoning: He cites housing demand, low interest rates, population growth, and a significant increase in home buying by people who used to rent, particularly those age 35 and under, for his view of the housing market.

Right now, Mr. Lieber likes home builders, which have become a favorite of short-sellers, who borrow stock, hoping to replace it at a lower price later. He notes that almost none of the publicly traded builders have exposure to the Miami condo market and that demand is outstripping supply. Among his favorites are Toll Brothers Inc., Horsham, Pa., and Lennar Corp., of Miami.

Mr. Lieber says he would be more cautious on housing if he were expecting a recession. "We think the fundamentals of the housing market are much stronger because of supply-and-demand considerations and the overall economic picture than many investors think or fear," he says.

10-Year Winner

The Bridgeway Ultra-Small Company Fund is down 2.5% this year. But that shouldn't faze its investors. After all, the portfolio owns the best record of all funds for the past decade, averaging 24.3% a year. (Its sister fund, Bridgeway Aggressive Investors I, is in second place for the 10-year period, with an annualized return of 22%.) "Bridgeway is all about long-term, not short-term, performance; so I'm very happy with these results," says John Montgomery, the funds' 49-year-old manager.

The funds' remarkable run is almost as remarkable as the story behind them.

In 1991, Mr. Montgomery, then an amateur investor, left his job as a bus-operations specialist for the Houston Metropolitan Transit Authority to start a mutual-fund company, after successfully managing his own investments. Two years later, he started Bridgeway with little more than his own money and a dream to "build a better mousetrap."

In the early days of the company, Mr. Montgomery struggled to gain the attention of fund researchers, who ignored his funds because they were so tiny, and the company didn't turn a profit for its first three years. The Houston-based company now has 11 funds.

In the 10 years since their launch, Bridgeway's funds have been lauded for their performance and Mr. Montgomery has been praised for his commitment to shareholders.

In addition, the firm gets high marks for its stewardship of investors' money, and the firm is known for charitable giving (50% of advisory-fee profits). Mr. Montgomery also has become known in the mutual-fund industry for being outspoken on such issues as salary disclosure (he reveals his salary and has called on other money managers to do the same). He also regularly warns investors about one of his pet peeves: performance chasing.

Mr. Montgomery and his team use quantitative models to choose tiny stocks, usually with market caps of less than $285 million, trying to beat the fund's index, the Center for Research in Security Prices Cap Based Portfolio 10 Index.

"A lot of these stocks have no analysts following them, and consequently, it's easier to find 'mispriced' stocks" he thinks will beat the index, he says. But he notes, stocks in this asset class aren't as "cheap" as they were five years ago.

As of March 31, the fund's top three holdings were Deckers Outdoor Corp., Hansen Natural Corp. and Petroleum Development Corp. Deckers, a Goleta, Calif., footwear maker, has dropped 46% so far this year. Hansen, a beverage holding company based in Corona, Calif., is up 131%, while independent energy producer Petroleum Development in Bridgeport, W. Va., is off 11.8%.

Though Mr. Montgomery notes that ultra-small stocks can diversify a normal stock-market-based portfolio, he cautions that they can be very volatile. "You better have a long time horizon for investing, or they are likely to disappoint you at some time," he says.

The one mark on Bridgeway's chart is the company's error in calculating performance fees in three funds, including the Aggressive Investor I fund, that resulted in investors being overcharged. In September 2004, the fund company paid a Securities and Exchange Commission fine of $4.4 million, plus interest, and Mr. Montgomery explained the situation and the firm's remedies with his typical candor, apologizing to shareholders on Bridgeway's Web site. Morningstar has said it continues to believe the company is a good steward of investor resources despite the error.

With that behind it, Bridgeway is maintaining its vision of creating shareholder value by, among other things, avoiding soft dollars from the beginning and closing funds before size affects performance. Bridgeway closed the ultra-small company fund to all investments, even from existing shareholders, at $55 million in assets. However, it recently reopened a passively managed fund, Bridgeway Ultra-Small Company Market Fund, that invests in the same tiny asset class.

Mr. Montgomery says he and Bridgeway executives have accomplished what they set out to do 10 years ago, but he adds: "Of course, history is history; what's more relevant is the next 10 years, and I'm pretty excited about that, too."

-- Ms. Egodigwe is a writer in New York. She can be reached at reports@wsj.com.

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