Energy the ‘05 sector story

In some ways, the last year could be seen as part II of 2004, with the continued outperformance of dominant sectors like natural resources and real estate. But subtler themes also emerged in 2005, including a long-awaited shift toward growth stocks, which have finally started to outperform value issues.

With domestic equities posting less than stellar gains – the Standard & Poor’s 500 has advanced barely 4 percent for the year – sector investing became the new favorite tool of many individuals. Funds invested in emerging markets enjoyed a particularly awesome 2005, at least in part due to the rally in oil, gas and other natural resources, which are major exports of many developing nations, noted Russ Kinnel, director of funds research at Morningstar Inc. Diversified emerging markets had surged 28 percent through November; Latin America funds were up 53 percent.

Energy was the story of the year, with natural resource funds rising 44 percent. Indeed, energy emerged as an important factor across the spectrum, Kinnel said, even at the individual fund level.

“Real estate funds continued to enjoy decent returns, as well, averaging a healthy 12 percent, though the sector’s obituary has been written “at least once a month for the last year,” said Don Cassidy, senior research analyst with fund tracker Lipper Inc.

After six years of gains, market watchers say the real estate rally is showing signs of wear. Housing stocks suffered as rising interest rates took their toll, and wary experts see bearish signals everywhere – even on television, where housing speculation has become entertainment on shows such as TLC’s “Property Ladder,” Discovery Home Channel’s “Flip That House,” and A&E’s “Flip This House.”

If energy was the big sector story, the story of the year in terms of money flows was international funds, said Carl Wittnebert, director of fund flow research for TrimTabs Investment Research.

“International funds have taken in more money than the traditional open-end funds in the domestic area, although they have far less in assets,” Wittnebert said.

In general, however, it was a slightly disappointing year for fund flows, Wittnebert said, with early figures showing total equity inflows at $122 billion through November, compared to $178 billion for all of 2004. Flows into bond funds improved despite a rocky market, up $31 billion compared to a small outflow in 2004, though nowhere near the inflows of recession years like 2002, when bond funds surged $141 billion.

It was a difficult year for fixed income investors as the Federal Reserve steadily raised short-term interest rates. With the rate cycle so hard to predict, Kinnel and others say it’s a good time to be fairly conservative with bond investments. If bonds rally in the year ahead, going too short would be an error; an intermediate bond fund is probably a good call for most investors.

So what’s next? Contrarians like Kinnel and Cassidy are now looking for better performance from some of the market’s less-loved areas. Growth, which has underperformed value for the last several years, is particularly fertile ground, Kinnel said. Even some value managers, who make their living by bargain hunting, are finding attractive opportunities in traditional growth stocks, particularly in large caps.