Is this a buyer's market? After three near-phenomenal years, here are the funds shaping up as the best for 1998.

After three near-phenomenal years, here are the funds shaping up as the best for 1998.

For mutual fund investors, 1997 was the best of years--if you're willing to overlook a nagging, little blemish. The good news is a soaring stock market made it difficult not to make money. For the first half of the year, the Standard & Poor's 500 index was virtually unstoppable. In all, it finished up 33% for the year, despite a "Black Monday" sell-off on October 27 and the woes that faltering Asian economies inflicted on American companies, two factors that made the tail end of the year a bit shaky for investors. In fact, aside from a bit of turbulence in the last quarter, '97 was the third straight year that stocks raced off to double-digit gains, following 38% and 23% leaps in the S&P 500 in 1995 and 1996, respectively. That's a trifecta that hasn't occurred since the mid-'60's!

Mutual fund managers had a lot to smile about last year--and not merely for the reasons listed above. Investors were in no way shy about expressing their gratitude for bull market gains, flooding mutual funds with some $180 billion in new money, according to Morningstar Inc., compared with $174 billion in 1996. And, even when the going got rocky at year's end, the influx of money showed no sign of abating.

"In all, [1997] ranks as one of the best years ever for net inflow into funds," says Russ Kinnel, an editor for Morningstar, the Chicago-based company that monitors the mutual fund market. "And that should continue even if people think there's a rough year ahead. With retirement and college tuition bills placed squarely in their laps, it's hard to avoid mutual funds," he adds.

With so much good news, what possible downside could funds have? Well, for all of the glorious returns that rained down on investors, 1997 underscored the industry's dirty little secret: mutual funds underperform the market. In fact, only a precious few--225 out of nearly 2,500 stock funds around--actually outdid the benchmark S&P 500 index of the largest corporations. While index funds--those "no-frills investments" whose sole purpose is to mimic the S&P 500--had no trouble keeping up, stock funds trailed by quite a bit, mustering no more thin an average annual return of 24.36%. And if a 6% gap between the index and the average fund's performance doesn't seem like much, consider this: over five years, that kind of differential on a $100 investment would amount to $33 (or one-third of your money). To make things worse, the run-of-the-mill stock mutual fund eats up more of your money in expenses than an index fund.

But that wasn't the only cloud to turn up as an extremely good year came to a close. There are signs that making money in the market, almost a no-brainer over the last three years, will get a bit tougher in 1998. Besides a brief, yet sharp, downturn in the market and troubles in Asia, a number of companies turned in quarterly earnings that disappointed Wall Street and saw their shares slaughtered in the market. Witness Minnesota Mining & Manufacturing (better known as 3M), Oracle and Micron Technology, all of which suffered one-day drops of 10% or greater. And although economic pundits had warned of a slowdown in the double-digit earnings gains we've seen over the last few years, it was still not pretty to see shares pummeled. "In the year to come, with volatility likely to shake the market, it'll be important for investors to devote time in finding the right mutual fund, one with a good track record," says Chip Norton, managing editor of Standard & Poor's Web site, S&P Personal Wealth (www.personalwealth.com).

That's where we come in. This latest installment of the annual BLACK ENTERPRISE mutual fund roundup is designed to help you best gauge the market and invest wisely. We'll briefly go over what experts expect for stocks and bonds in the upcoming year and look at some of the best places to put your money. At the end of our report, you'll find a chart of the highest-ranked mutual funds, according to statistics compiled by Lipper Analytical Services, a Summit, New Jersey, firm that tracks the industry. In all, it's a package that will help you plan your initial plunge into the market if you're a first-time investor. Or if you're a seasoned mutual fund aficionado, we've pointed out fund groups that should shine during the balance of the year so you can better allocate your assets.

Before we dive in, here are the guidelines we've used in our report. First, we've focused solely on no-load mutual funds this year. Our reason is simple: load funds have you--the investor--pay a fee for covering the cost of advertising the fund.

For example, say a broker sells you on Fund X with a 5% front-end or initial load fee. Of the $1,000 you invest, $50 goes to the broker's firm for having sold you on the fund. Then, even if in that first year your fund racks up a return of 10% or $100, half what should be your gain is lost. Yes, some funds let you spread that fee out over time or will sometimes waive it if you stick with an investment for five years or more. Yet with newspapers, magazines and television all in the hunt for investment stories, we feel a high-flying fund attracts more than enough attention to sell itself.

Finally, no matter what your goals for the years ahead, it's best to approach mutual fund investing with a patient, long-term perspective. Over time, the stock market has averaged a 12% annual return. And though three blockbuster years in a row might have you feeling a bit feisty, we recommend that you keep any sum you place in mutual funds for three to five years. "Investors who are just now getting into mutual funds shouldn't have a target date that begins with a `19,'" says A. Michael Lipper, president of Lipper Analytical Services. "Instead, they should be looking as far out as the year 2010 by developing a portfolio holding a group of funds, and by being patient through thick and thin."

SIZING UP '98

You probably couldn't imagine a more idyllic backdrop for the stock market. The economy is growing, unemployment is low and inflation has fallen to minuscule levels. Corporate profits continue to rise, and interest rates--at their lowest since the late '60s--are falling, and that's before Congress hacks away at the federal deficit or approves a budget with a surplus. Put all those factors together, and there seems to be little reason why the stock market couldn't post another sizable gain in 1998, right?

Not so fast. True, one measure of how well the market will do--the percent corporate earnings or profits are expected to grow--points to a reasonably good year ahead. But the rate that America's bottom line is increasing has started to tail off. Last year, earnings growth figures for the S&P 500, which rose 11% in 1995 and 14% in 1996, fell back to an estimated 11%. And while some of the more optimistic experts out there think corporate profits should end the year up 8%, a more realistic figure might undercut that a bit, perhaps in the 5%-6% range. "Any corporation out there will tell you they want to do better than the average," says David M. Blitzer, vice president and chief economist for Standard & Poor's. "But obviously, there's going to be a number that fall below the mark."

A number of culprits are behind the squeeze on profits. Employment is rising, an indication that there should soon be upward pressure on wages. The last few years, a number of companies snipped healthcare costs by enrolling workers in managed care plans. Now that enrollment is nearly complete, that one time saving is behind us. In fact, there are concerns that companies will soon have to shell out more for their workers' doctor bills. Something else to keep in mind is the market's valuation. Currently, the S&P 500 is trading at a price-to-earnings (P/E) ratio of 21. Keeping in mind that the index has historically borne a P/E between nine and 22, it seems there's not much higher to go.

There are some positives to remember, however. For one, money keeps pouring into the market from retirement plans like 401 (k)s, and an increase in demand relative to supply could help propel stock prices up. A strong dollar and concerns about foreign markets will also make the U.S. market look attractive.

So what does all that spell for the year ahead? For one, don't look for another 30% gain in 1998. A lot of experts look for the market to rise during the year, but only a muted 10% or so at most. As for segments of the stock market, there are several things to consider. First, with uncertainty in Asia and earnings tailing off, large, defensive stocks--the household names that make up the S&P 500--should do well. "When investors big and small get worried about what's to come, they head for yesterday's winners, the big large-cap stocks that have done incredibly well over the last three years," says Blitzer. As earnings growth weakens, value stocks--those trading at a P/E less than the overall market--stand a very good chance of delivering good returns. Finally, with interest rates falling, the bond market looks to do well.

A Guide To BE's List of Top Funds

This year, BLACK ENTERPRISE has focused our annual list on the top "no-load" mutual funds. The top tier in each investing category is ranked according to its three-year average annual return to include as many of the newer funds as possible. As anyone who follows the business knows, everyone and their broker it seems has come up with a new mutual fund during the last few years. Between 1990 and last year, the roster of funds had roughly doubled, going from 2,900 to nearly 7,000 with no end in sight.

Happy hunting.

INDEX FUNDS

If Madison Avenue's advertising gums were to put a little brainpower behind a slogan to sell index funds, it might run a little like this: "Less Hassle, Better Results." As the investment industry's no-frills product, index cost little to put together and are simple to manage. They buy up all the shares that belong to an index--more often than not the S&P 500--then sit back and let their portfolio to go to work mimicking the ups and downs of the stock market. That's been a lucrative strategy over the past few years, especially considering the average total return for equity funds in the past five and 10 years has been 17% and 15%, respectively, while index funds have posted 20 and 17% for the same periods.

And for the frugal investor, index funds spend less of your hard-earned money on operations. Since index funds have a low portfolio turnover and trade infrequently, they save money. A well-run index racks up expenses amounting to no more than 0.2% of its assets, compared to an average 1.5% for equity mutual funds. "Indexing is one way to play the market and minimize risk," says Sam Weiser, national director of Ernst & Young's Investment Advisory Services. "And in terms of costs the funds are far cheaper than actively managed ones."

The success index funds have enjoyed could well continue through 1998. Index funds stand a good chance of beating out actively managed stock funds whenever investors flock to the largest, most visible corporations as a hedge against market volatility. That's what propelled the S&P 500 in 1997. With investors a bit nervous about the market and unsure that stocks can continue their tremendous gains, the large capitalization stocks look to continue to do well this year.

There's another plus to investigating in index funds this year. The same large companies in the S&P 500 whose stocks have done well are using their shares in a shopping spree of acquisitions. And, what better targets than other large companies? says Standard & Poor's David Blitzer. "We've seen that a number of the companies in the index have been take-out targets over the last couple of years, and of course, that only helps the index."

Does that mean index funds are infallible? Not quite. One instance where they could end up trailing actively managed mutual funds would be if stocks slid over the coming year. The reason: index funds must invest every cent of their money and aren't allowed to hold a cash position no matter what's taking place in the market.

Index funds, though, aren't included in our annual ranking for one reason: shopping for them boils down to finding the company that runs the most frugal, penny-pinching operation, one that won't eat into your returns with a lot of unnecessary expenses. Hands-down, fund industry experts say the most efficient operator out there is Vanguard, the company that invented index funds. And, the same pros will tell you that the investment of choice is the Vanguard Equity 500 (800-662-7447) a fund designed to track the S&P 500 at the lowest cost possible.

LARGE CAP FUNDS

Forget that small company stocks historically outperform big corporations. The same concerns that helped large-cap stocks shine in '97 are likely to give them a leg up in '98 as well. At the beginning of last year, investors looked for safe, dependable names--highly visible companies they felt could weather volatility in the market. Experts say we're likely to see a repeat of that same scenario this year.

Not that you'll give up too much in performance for sticking with Wall Street's mammoths. Over time, growth, growth & income, capital appreciation and equity income--four Lipper categories that track large-cap funds--have averaged total five-year returns of 16.82%, 17.63%, 15.70% and 17.14%, respectively. Stack that up against a 16.74% record for small-cap funds and 15.45% for mid-caps over the same period, and it's clear that you haven't lost much in the way of return.

BOND FUNDS

Pay no attention to the fact that bond funds outperformed their equity counterparts during the last quarter of 1997. Over an extended period, you won't beat the market investing in bond funds, nor will you exactly hit the jackpot. The proof: domestic long-term fixed income funds, according to Lipper, have returned an average 7% over the last five years compared to nearly 16% for equity (or stock) funds.

So what good is bond fund investing? Well, in a year where the stock market seems destined to pass through some choppy waves, bond funds are a good place to safely stash a part of your portfolio while earning a healthy return on your money. And, the timing couldn't be better. Experts like Mark Lay of MDL Capital Management see "How Much Higher?" in this issue) believes rates will fall during the first half of the year, helping bond funds net a nice sum in capital gains.

Make no mistake, however, if you're looking for the steadiest and safest of yields, we'd recommend buying and holding U.S. Treasury bonds until their maturity. Where stock funds actually diminish risk through a diversified portfolio, bond funds don't. Bond funds aren't held to keeping a set portfolio; they can buy and sell holdings at will, and will often do so to lock in gains or prevent further losses. That constant shuffling of assets makes bond funds act like stock funds, only with less in gains over time.

With that in mind, our list includes general bond funds, mixing corporate and government debt, and those that invest in government agency debt--an asset class practically as safe as Treasury bonds, yet offering a bit more punch for your money.

BALANCED FUNDS 

Maybe you're looking to combine the growth of stocks with the shelter of bonds. If so, balanced funds could be your answer. By straddling both markets, balanced funds provide the best of both worlds: a stock portfolio with a 30% to 40% mix of bonds as a hedge when stocks have their troubles. For evidence, just look to the fourth quarter of 1997. Although equity funds on average lost 1.54% for the period, balanced funds managed to eke out a 1.15% total return, thanks to a strong bond market.

INTERNATIONAL FUNDS

Who in their right mind would poke their nose overseas in a year when practically every Pacific Rim nation west of Honolulu is caving in? An astute investor, that's who. "If you're young and adventuresome, it's not a crazy time to look overseas," says A. Michael Lipper. "And in some cases, you'll find some bargains, if you're willing to stick it out." Or, as Sam Weiser, says, "if you don't have any exposure to overseas markets, now might be a good time to take the dive."

While we won't steer you toward Asian funds just yet, especially when the IMF is still ironing out details of several bailouts in the Far East, consider a few things. First, many analysts say European economies are due for a recovery this year. Second, Latin American funds have outperformed domestic stock funds for the past two years. Looking over time, you'll see that the Morgan Stanley EAFE index of European and Asian markets has posted an average annual return of 20% over the last five years and 16% over the last decade--impressive numbers that are comparable to figures for the S&P 500.

"The outlook is good," says Wayne Weddington, president of Pennoyer Capital Management, a Manhattan international investment firm. "Our money is not in Japan, but Japan is up over 11% in January alone, a sign that troubles there could be over," he notes. "And Switzerland, the U.K., Ireland and the Netherlands are all markets that could outperform the S&P 500 by 20% this year."

Still chicken? Well, our list provides you a number of ways to invest abroad. If you're up for a pure play of investment overseas, look at the list of international funds. If you'd still like to hold onto American shores a bit, global funds are a good way to mix U.S. market exposure with overseas stocks. And finally, if you've got no stomach to venture outside the country, you'll be glad to know that investing in the largest U.S. companies is often considered an indirect means of tapping into the global economy since many have interests abroad.