The New Year began without any specific disasters to test the markets, and stocks continued their upswing in the first quarter. "It was a neutralish to positive sort of quarter," says Jack Robinson, president of Winslow Management Co. Some of the biggest gains occurred abroad, while domestically, growth outperformed value in all but the large-cap category.

All Morningstar diversified domestic stock fund categories posted gains in the first quarter, with small caps leading the charge. Small caps "have been unquestionably on fire," says Robinson. The category gained 12.6% this year (compared with 6.1% for the Nasdaq), followed by mid caps at 8% and large caps at 4.2% (versus 4.5% for the S&P 500).

Large-cap growth funds failed again to take off, and expectations for the asset class have finally begun to cool, says Jeff Tjornehoj, a research analyst at Lipper. Large-cap growth funds posted a mere 2.1% gain for the quarter, compared with 6% for large-cap value funds.

In other categories, growth trounced value in what may signal the start of a longer-term predominance, says John Coumarianos, a mutual fund analyst at Morningstar. Mid-cap growth bested mid-cap value, 9.4% to 6.6%. Returns for small-cap growth rose 13.3%, outperforming small-cap value at 10.6%.

International equity funds returned 10.2% on average, outpacing domestic equity funds by 5.7%. Latin America continued to lead the pack, up 14.6%, fueled by natural resources and commodities, Coumarianos says.

Europe's strong quarter of 11.8% gains came as a surprise. "I just don't get it," Tjornehoj says. He expected the high consumer savings rate in Germany, Europe's largest economy, to act as a drag on the region's growth.

INTEREST RATE IMPACT

Overall, equity fund flows have been fairly active compared with the end of 2005, says Carl Wittnebert, director of fund flow research for Trim Tabs Investment Research. The fourth quarter last year saw net new cash inflows of $37.3 billion, according to the Investment Company Institute. Estimates for the first quarter of 2006 are considerably higher, at $74.1 billion.

This increase may not signal a prolonged pickup, however, since most of it occurred in January and February; net cash inflows for March are estimated at only $14 billion, Wittnebert predicts. To put that in perspective, he says, a blockbuster quarter from 2000 had net cash flows in the vicinity of $120 billion.

Real estate investment trusts defied expectations by continuing to climb in the face of rising interest rates. The sector was up 12%. "Real estate ruled the roost again, and it's kind of surprising," Coumarianos says. Uncertainty about inflation continues to buoy hard assets such as real estate and gold, Tjornehoj says.

While big pharmaceuticals lagged, biotech had a breakout quarter. The three ETFs that cover the sector, with a combined $2.3 billion in net assets, saw net new cash flows of $500 million in the first quarter, up from $37 million in the previous quarter, Wittnebert says.

Although rising interest rates failed to restrain real estate, they did take a toll on bonds. The Lehman Brothers Aggregate Bond Index dipped 0.7% for the quarter, and the Lehman Brothers Mortgage-Backed Securities Index declined 0.1%. Junk bonds, on the other hand, are "still chugging along," Coumarianos says, with gains of 2.8% for the quarter.

For all bonds, "it looks like the longer yields are creeping up," Coumarianos says. After resisting the Fed's increases in short-term rates, "now you're finally starting to see them succumb." Even so, the increase in the longer end hasn't resulted in a steeper yield curve because short-term rates are also rising. So far, bond gains this year have been "pretty paltry," Coumarinos observes, and the difficult environment will likely continue.

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