Go where the money is: funds that focus on the financial services industry offer outstanding long-term performance.

Sometimes a contrarian investment can pay off in the long run. Such is the case now with financial services mutual funds, which hold the stocks of banks, brokerage firms, insurers, and other financial companies. As of August, these funds had gone up less than 1% for the year. Investors would have been better off going to a bank and putting their money into a CD. But that's not the whole story behind these funds.

"A lot of people equate lower interest rates with higher earnings when it comes to financial stocks," says Laura Pavlenko Lutton, an analyst at mutual fund tracker Morningstar, but that hasn't been the case this year. Since the Federal Reserve has been raising interest rates and has signaled that it will continue to do so, financial stocks have lagged. As the Fed has moved to boost short-term interest rates, long-term interest rates have stayed unexpectedly low.

"Considering that oil is trading at over $60 a barrel, and the Federal Reserve has been raising rates, it's surprising to see the 10-year Treasury yielding around 4%," says Mike Blatt, a portfolio manager with Chemung Canal Trust Co. in Elmira, New York. The result is that banks are being forced to pay depositors higher yields on savings accounts, but they haven't been able to raise the interest rates that they charge on loans. This has squeezed the profit margins of banks, hurting their stocks. Banks such as Citigroup, Bank of America, and JPMorgan Chase are the largest holdings in this category of mutual funds, according to Morningstar.

The silver lining in all of this is that now, financial services mutual funds have the lowest price-to-earnings ratios, price-to-book values, and price-to-cash flow of all stock fund categories. Put plainly, these funds are cheap. Moreover, these funds have been great long-term performers. Over the last 10 years, they've returned nearly 14% per year, a record few other categories can match. To put that in perspective, if you had invested $10,000 in 1995 and it grew 14% each year, you would now have $37,000, despite the 2000-2002 bear market. "You can go back even further, to the past 30 years, and see that the financial services sector outperformed the broader market," says Raymond Stewart, chief investment officer at RASARA Strategies, an asset management firm in Briarcliff Manor, New York.

Since financial services mutual funds have already taken a hit, things could improve quickly. "It can be a mistake to equate low interest rates with higher earnings for all financial stocks," says Lutton. "Insurance companies go through cycles that may not correspond to interest rate movement, In addition, if interest rates move up from here, that may be a sign of a stronger economy, which would be helpful for the stock market and for brokerage firms, The financial services sector is more diverse than many people realize."

In fact, now might be the right time for financial services mutual funds. When the Fed stops raising interest rates, these stocks often outperform, and many observers think the current round of rate increases will come to an end in late 2005 or 2006.

Although investors shouldn't overload on financial services mutual funds, a fund in this category might merit a small place in a well-diversified portfolio. "Investors who have growth-heavy portfolios might use these funds for balance," says Lutton. That is, a financial services mutual fund that holds value stocks could steady a portfolio tilted too far toward growth stocks.

If you're interested in financial services mutual funds, a couple of Morningstar analyst picks are the Davis Financial (RPFGX) and T. Rowe Price Financial Services (PRISX) funds, both of which spread their holdings over many different types of companies.

TOP FINANCIAL SERVICES MUTUAL FUNDS RANKED BY 3-YEAR RETURN

                                                        3-Yr.
                                            1-Yr.     Annualized
                                            Total       Total
Fund Name                         Ticker   Return *    Return *

Merrill Lynch Global Financial    MBFNX     37.01%      25.60%
  Svcs B
Forward Emerald Banking and       HSSAX     21.39       23.12
  Finance A
Fidelity Select Brokerage &       FSLBX     39.19       21.56
  Investmnt
FBR Small Cap Financial           FBRSX     15.12       19.78
Diamond Hill Bank & Financial A   BANCX     12.31       19.46
Burnham Financial Services A      BURKX     11.39       18.97
Gartmore Global Financial A       GLFAX     16.38       18.78
Constellation TIP Financial       TFFIX     21.36       17.68
  Services
AXA Enterprise Global Financial   EGFAX     18.74       16.19
  Svc A
Schwab Financial Services         SWFFX     22.22       16.16

                                    5-Yr.
                                  Annualized   Minimum
                                    Total      Initial
Fund Name                          Return *    Purchase   Phone Number

Merrill Lynch Global Financial      14.86%       $1,000   800-995-6526
  Svcs B
Forward Emerald Banking and         22.85           500   800-232-0224
  Finance A
Fidelity Select Brokerage &          6.09         2,500   800-343-3548
  Investmnt
FBR Small Cap Financial             24.90         2,000   888-888-0025
Diamond Hill Bank & Financial A     24.72        10,000   888-226-5595
Burnham Financial Services A        25.56         2,500   800-874-3863
Gartmore Global Financial A            NA         2,000   800-848-0920
Constellation TIP Financial          7.71         2,500   866-242-5742
  Services
AXA Enterprise Global Financial     10.51         2,000   800-368-3527
  Svc A
Schwab Financial Services            8.71         5,000   800-435-4000

SOURCE: MORNINGSTAR INC.

MORNINGSTAR MAKES EVERY EFFORT TO ENSURE THE COMPLETENESS AND ACCURACY
OF THIS DATA BUT CANNOT GUARANTEE IT.

* RETURNS THROUGH JULY 31, 2005, SINGLE SHARE CLASS, RETAIL ONLY,
OPEN TO NEW INVESTORS