How Funds Will Fare in 2008

To stay on top of changing trends, investors have to stay one step ahead of the crowd. Those who successfully identify trends before they happen can outperform the markets routinely.

Nowhere is that clearer than with 2007's mutual fund performance. Although the S&P 500 was up by a mediocre 6% or so, many pockets of strength and weakness were within the broader markets. A look at the trends that made money for mutual fund investors last year will reveal clues to the best places for your money in 2008.

Finding value in growth
For many years, funds that emphasize value stocks had outperformed their growth fund counterparts by a wide margin. As Amanda Kish, our Champion Funds newsletter analyst, correctly foresaw as early as April, growth trounced value during 2007. Over the past year, large-cap growth funds have risen 8.25%, while large-cap value funds fell nearly 2%. With smaller stocks, the disparity was even more dramatic, with small-cap value funds down over 11%, while small-cap growth funds eked out a 2% gain.

These results correspond with the economic trends that prevailed during 2007. Value stocks include many sectors that were beaten down in 2007, most notably financial stocks like Citigroup (NYSE: C  ) and Washington Mutual (NYSE: WM  ) . Meanwhile, growth stocks compose many of the sectors that did well last year, such as technology companies Research In Motion (Nasdaq: RIMM  ) and Oracle (Nasdaq: ORCL  ) .

The underlying question for 2008 is whether the worst is yet to come for the financials. Value continues to be dominated by financial stocks, so if financial services companies and banks have bottomed out, then look for value funds to regain the ascendancy they've enjoyed for most of the decade. But if you think there'll be more damage in the financial sector, then growth will continue to outperform, despite increasing fears of a recession this year.

Winning around the world
Mutual funds that hold international stocks again outperformed U.S. stock funds but by a less substantial margin than in recent years. The average world stock fund returned a bit more than 8% in the past year, well off its five-year average pace of 17%. Again, performance was weighted toward emerging markets, as funds specializing in developing areas rose an average of 34%.

With the strong performance of emerging market economies translating into huge growth for stocks like Petroleo Brasileiro (NYSE: PBR  ) and China Life (NYSE: LFC  ) , it's not surprising to see funds cashing in. Yet some of the tailwinds that have bolstered foreign stock returns, such as the falling dollar and a strong U.S. import market, are starting to weaken. That trend is evident in Japanese stock funds, which have fallen an average of 12% in the last 12 months. The dollar will rebound, and when it does, U.S. funds will become more competitive again with their international rivals.

Active managers win
Actively managed stock funds often take heat from index fund proponents for not delivering enough performance to offset their higher costs. Yet, at least in 2007, managers scraped out a victory, with the average fund up 6.85% -- almost 1% more than the S&P 500.

Nevertheless, it wasn't all good news for actively managed funds. After underperforming the S&P 500 during 2006 for the first time in 15 years, fund guru Bill Miller lost to the market again last year. A number of other strong fund managers had similar winning streaks broken in 2007.

All this proves that mutual fund managers have as much trouble predicting trends in the markets as anyone. That's why diversification is so important -- when you can't identify a strong reason to make a concentrated bet, hedging your bets with funds that invest in a variety of asset classes and sub-classes helps avoid major mistakes.

Fads come and go, but in the long run, finding fund managers who can consistently beat the market will help you do well.

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