VFINX Vanguard Index Trust 500 Index Fund (MM)

   By Jonathan Burton 
 

Mutual fund and exchange-traded fund investors embraced U.S. stocks again in the opening weeks of the year, only to be reminded of why they'd fled.

Black swans, those unexpected market-moving events, appeared in several places at once. Upheaval in the Middle East and North Africa, Japan's devastation, and doubts about the strength of the U.S. economic recovery had shareholders mobbing the corner of Wall Street and Worry Street for several harried weeks in the first quarter.

The uncertainty fed market volatility and sacked the broad U.S. market. The benchmark Standard & Poor's 500-stock index slid more than 6% from mid-February until the day after the ides of March.

By then, many retail investors had seen enough. Too bad they didn't hang around to capture the S&P 500's best first-quarter since 1998.

After pumping almost $22 billion into domestic stock funds in January and February, shareholders pulled about $8.5 billion from these investments in subsequent weeks through March 23, according to the Investment Company Institute, a fund industry trade group.

Indeed, stock-buying sentiment in mid-March was lower than at any time since last August, the American Association of Individual Investors reported, and the percentage of bulls in its March 23 survey, though higher, remained below-average.

Yet, as is often the case, panicky sellers exited just as U.S. stocks found their footing. Diversified U.S. stock funds gained 6.6% on average in the quarter through March 30. Every stock-fund category that investment researcher Morningstar Inc. tracks finished the period in positive territory -- though there was a 10-point spread between leader energy funds (up 12.6%) and laggard consumer staples funds (up 2.5%).

The S&P 500, meanwhile, posted a 5.4% quarterly return, not including dividends, thanks largely to soaring energy shares and a late March rally, according to preliminary Morningstar data. The Dow Jones Industrial Average weighed in with a 6.4% advance, its best first-quarter result since 1999. A representative exchange-traded fund, SPDR Dow Jones Industrial Average, mirrored that performance.

The U.S. market's showing trumped returns for diversified international stock funds, which gained 2.6% on average.

"The first quarter was a relatively good investment quarter for most," said Jim Tierney, chief investment officer at investment manager W.P. Stewart. "The fact that the market has held in is remarkable, and positive."

 
   Change From A Quarter 
 

Indeed, the first 13 weeks of the year wound up being generous to fund and ETF investors, regardless of whether they favored small-cap, midcap or large-cap portfolios.

Small-cap growth funds led the pack with an average gain of 8.8%, while their midcap rivals added 7.6%, and large-cap growth measured a 5.5% advance, Morningstar reports.

Among stock funds with a value discipline, midcap products rose 7% on average, followed by small-cap value funds' 6.5% return and large-cap value funds' 6.2% gain.

The best diversified mutual fund of all: Integrity Williston Basin/Mid-North America Stock Fund (ICPAX), up 20.5% in the quarter. Sizable positions in energy stocks including National Oilwell Varco Inc. (NOV), Baker Hughes Inc. (BHI) and Hess Corp. (HES) spurred this midcap growth fund forward.

The biggest U.S. stock funds reflected the broad-market returns.

Vanguard 500 Index Fund (VFINX), which tracks the S&P 500, rose 6.1% including reinvested dividends. Actively managed American Funds Growth Fund of America (AGTHX) added 5.3%, Fidelity Contrafund (FCNTX) was up 4.9%, and Dodge & Cox Stock Fund (DODGX) gained 6.3%.

Funds dedicated to energy companies were the biggest sector winners, posting a 12.6% average gain, and portfolios invested natural resources added 7.6% on average. Fifteen of the quarter's 20-best ETF performers were tied to energy and commodities, Morningstar data show.

The top-performing ETF was the 300% leveraged Direxion Daily Energy Bull 3X Shares (ERX), which rose 54.4%. Other ETF standouts: iPath DJ-UBS Cotton TR Sub-Index ETN (BAL), up 38.1%, and PowerShares S&P SmallCap Energy (PSCE), up 24%.

But surprisingly strong results came from health-care-related funds, up 7.2%, and real estate funds, up 5.3% in the period. And precious-metals stock funds were surprisingly weak, losing 3.4% on average.

Technology funds, meanwhile, rose 5.9%, which doesn't fully reflect the enthusiasm many fund managers have for the sector.

"Technology has these big waves of investing every 10 years or so," said Bob Turner, chief investment officer at Turner Investment Partners and manager of the tech -- heavy Turner Large Growth Investor Fund (TCGFX), which gained 7% in the quarter.

Turner is especially keen on predictions of rapid growth for mobile computing--smartphones and tablets--and so-called "cloud" computing. Companies he expects to ride the mobile wave include Apple Inc. (AAPL), Cisco Systems Inc. (CSCO), while he sees Salesforce.com Inc. (CRM) taking a leading role in cloud computing.

 
   Get Up, Stand Up 
 

Now comes the hard part.

The first quarter came in like a bull and went out like a bull. U.S. stock funds and ETFs weathered the exogenous shocks of Japan and the Mideast; the market absorbed oil spurting above $100 a barrel and an ounce of gold fetching record prices.

Investors have whistled past a graveyard of deflating housing prices, a weak U.S. dollar, shaky consumer confidence and rising food and other commodity prices.

Bulls are encouraged that U.S. corporations are in reasonably good financial shape. S&P 500 company earnings for the first quarter are expected to be fairly robust -- up 14% year over year, according to Thomson Reuters, with the materials, industrials and energy sectors posting the strongest showing. S&P analysts, in fact, recommend that investors emphasize those three sectors, in addition to technology.

"The easy money off the bottom has been made," Turner said, "but we have a safety net beneath the market: solid corporate earnings, record levels of cash, free cash flow, and cash on the sidelines." He looks for the S&P 500 to "grind higher" and finish the year at around 1,400 -- about 6% above its March 31 close of 1,326.

But what if this is as good as it gets? Analysts at S&P have a target of 1,400 for the S&P 500 as well -- they just see it hitting 1,400 by May, tumbling 10% to 20% in a full-fledged correction that bottoms in the third quarter, and then climbing back to 1,400 in 12 months.

Many fund investors and portfolio managers are proceeding with caution.

"I'm ambivalent about the markets," said Jerry Jordan, manager of Jordan Opportunity Fund (JORDX), which gained 4.4% in the quarter. While optimistic about U.S. companies' ability to compete globally in coming years, he said: "I don't think you have to chase anything."

There's growing concern about the after-effects on the economy if the Fed ends its so-called QE2 stimulus at the end of June as planned, and indeed, if the central bank moves to raise interest rates.

"You have to have some way of hedging yourself if things get worse, but participate as things recover," added Ed Peters, who runs Managers AMG FQ Global Essentials Fund (MMAVX), which gained 1.8% in the quarter.

To that end, many fund managers are laser-focused on companies, especially large- and mid-sized enterprises, with cash on hand and pricing power for their goods or services -- or as W.P. Stewart's Tierney put it, businesses that "have their own motor."

The biggest problem, as Tierney sees it, is that rising energy, commodity and materials costs will keep pressure on margins, so companies that can't readily pass along higher costs to customers will have a tougher road.

"Keep an eye out on corporate margins," he said. To thrive in this new economic climate, he added, companies will need "significant revenue growth or significant free cash flow," he said.

"Pricing power will be a much more important characteristic for a company to have in the next five years," added Larry Pitkowsky, founder of GoodHaven Capital Management in Miami.

Considering all of the open questions about the economy's strength, it's hardly consensus that this patient can walk unassisted come June. Yet, precisely because those fears may be overblown, investors are likely to remain on edge -- and it's here that savvy buyers can find opportunities.

David Rosenberg, chief economist and strategist at Toronto-based investment manager Gluskin Sheff, advised clients in a quarter-end research note to favor higher-quality companies, specifically "cash-flow generators with strong balance sheets that pay out a reliable dividend stream." He's also upbeat on energy and commodities, as well as precious metals.

"We fully expect another roller coaster ride in the markets this year," Rosenberg said. Accordingly, he added, "We must be very well prepared to take advantage of the stepped up volatility."

(Jonathan Burton is MarketWatch's investments editor, based in San Francisco. He can be reached at 415-439-6400 or by email at AskNewswires@dowjones.com.)