Due to tensions in the Middle East, skyrocketing oil and gas prices and inflationary concerns, the third quarter started off sluggish. Equity funds in July returned a negative 1.1%, but as the Federal Open Market Committee began to ease up on interest rate hikes and oil prices declined 7% in August, in the end, domestic equity funds posted gains of 1.98%, Lipper's third quarter mutual fund review and outlook found.

The report highlighted that investors are still cautious and income-orientated, preferring higher-quality earnings and dividends, and have been shifting to favor large-cap funds from small-cap funds.

For the first time since the fourth quarter of 2002, Standard & Poor's 500 Index-objective funds topped the list with 5.51% returns.

"There is always talk about the small-cap phenomenon, but investors are taking a more conservative approach with big names and strong earnings," said Tom Roseen, a senior research analyst with Lipper of New York.

Investors are cautious, as indicated by the 5.05% returns in income-orientated funds in the quarter, he said. Large-cap value funds posted returns of 5.38%, outperforming large-cap growth funds' average returns of 2.56%. It was the first time since the third quarter of 1998 that large-cap funds, which rose 4.16% overall, posted two consecutive top-performing quarters. Small-cap funds had negative 1.28% returns overall, and small-cap growth funds, comprised of transportation, energy, minerals and industrial services sectors, posted negative 2.74% returns.

Sector equity funds posted gains of 3.94% in the third quarter, despite a 15% decline in oil prices during the quarter. Real estate funds led the way with 8.35% returns, which might seem a little surprising considering the uncertainty surrounding housing prices, but interest remains strong in income-generating commercial real estate through real estate investment trusts. Real estate is the only sector class that can boast seven consecutive years of positive performance, Roseen noted.

Not far behind real estate were utility funds, with an average return of 6.26%, and telecommunication funds, which posted average gains of 5.94%. Taking a big hit were natural resources funds, which fell 8.40% in the quarter, primarily due to a 15% decline in oil prices during the quarter, Lipper said.

Normally, the third quarter is the slowest for financial services funds, but it was quite the opposite this year, with financial services funds returning 5.52%. Large banks posted high returns from trading revenue, increased mergers and acquisitions and debt offerings.

The high returns are expected to continue next quarter, said Ashwani Kaul, senior research analyst with Reuters Estimates of New York. "There is a lot of money for financials to make, and they are taking advantage of it."

Looking abroad in the third quarter, world equity funds posted a gain of 3.44%. Pacific ex-Japan funds boasted the best in the group, with gains of 5.99% and particularly strong returns from Hong Kong, Singapore, and South Korea. Latin American and emerging-markets funds boasted returns over 5%.

The U.S. trends-such as multi- and large-cap funds beating small- and mid-cap funds, and value funds favored over growth funds-were seen internationally as well.

World equity funds would have posted even stronger returns but were mostly dragged down by gold-oriented and Japanese funds, which had negative 6.38% and negative 2.04% returns, respectively, Lipper said. They were the only two funds that posted negative returns in the world equity category. Japanese funds were pulled down by the financial, producer manufacturing and process industries sectors.

Lipper also reviewed fixed income funds for the quarter. The bond market was refreshed due to the Federal Reserve's pausing rates for a second time last month, the uncertainty in the economy and the decline in housing prices, said Jeff Tjornehoj, a senior research analyst with Lipper. The average fixed income bond fund returned 3% in the quarter. However, wages, spending and jobs are still in growth mode, he said.

Corporate mortgage and bonds are on pace to reach record levels and overall did fairly well and did not lag too much, he said. Treasury funds yielded an average return of over 2%. They typically do quite well and have good returns for investors, but after the Fed pause, they were largely ignored, Tjornehoj said.

Looking forward, the earnings growth of companies in the S&P 500 is expected to reach 14.1% for the third quarter, compared to 13.2% in the same period last year.

On a sector basis for the year, basic materials and financial sectors are expected to show the largest year-over-year earnings gains, with 40% and 20%, respectively, Kaul estimated. A handful of financial firms have reported earnings, and thus far the numbers look very strong, he said. The non-cyclical consumer goods and service and technology sectors are expected to show the least favorable earnings gains, with a 2% gain and a 2% decline, respectively.

Commenting on the coming months, Roseen is not very bullish on the fourth quarter due to the mid-term election next month, which could disrupt market volatility if there are major changes. Anytime there is a possible change in leadership, especially in the House or Senate, it plays on investors' minds a bit, he said. Tax costs will come into question, as well. Additionally, there is uncertainty over whether the Fed will increase rates further.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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