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M&As, Earnings Focus Boost Funds in Second Quarter

Second quarter's market performance was impressive due to record mergers and acquisitions, and investors focusing on corporate earnings and not worrying about signs of future inflation or a slowing economy, according to Lipper's second quarter review and outlook webcast last week.

"Last month sent a little jitters into the market, but overall the second quarter has been fantastic," said Tom Roseen, a senior analyst at Lipper in New York.

For the quarter, despite poor performance in June, equity funds increased 6.30%, compared to 2.41% in the first quarter. Large-cap companies beat small-cap once again, but mid-cap companies won the race, Roseen commented. For the second consecutive quarter, growth also beat value.

April and May were particularly strong months, with equity funds rising 3.52% and 3.65%, respectively. The 41 M&A deals in May kept returns propped up and investors chasing the winners, Roseen said.

In June, equity funds shed 0.95%, which was possibly due to the treasury market looking more attractive and investors willing to leave the volatile equity market to seek alternatives. Additionally, crude oil prices rose to $70 a barrel. Only 24% of equity and mixed equity funds posted positive returns for June, he noted.

U.S. diversified equity funds climbed 6.17% in the quarter, and for the first time since the second quarter of 2006, the funds performed better than sector equity funds. Mid-cap funds and growth-orientated funds delivered the strongest returns for the second quarter, gaining 7.19% and 7.35%, respectively. The best returns among diversified funds were from mid-cap growth funds, up 8.13%.

In regard to sector equity funds, natural resources funds were the highest performing, rising 14.67%. In June alone they increased 8.8%.

Telecommunications funds increased 11.14%, due to strong earnings reports, the introduction of Apple's iPhone and private equity takeouts, Roseen said.

On the other hand, real estate funds declined and had the only negative returns in the group, sinking 7.96%. Real estate funds have tanked the last few quarters after five years of good performance, Roseen noted. Now they are in the doldrums, he said.

Other underachievers included financial services funds, with scant gains of 1.95%, utility funds, up 3.43%, and health and biotechnology funds, eking out 0.3%.

For the third successive quarter, world equity funds performed well, rising 8.30%. In fact, all international funds had positive returns. However, Japanese funds saw a negligible rise of 0.09%, but this might improve next quarter now that the dollar has strengthened from the yen, Roseen commented.

China posted stellar returns of 21.53%. Certainly, there has been some argument that China's red-hot market will cool down a bit, Roseen said. Globally, large-cap funds beat growth and value, as they have steady dividends, economies of scale and large international offerings, Roseen commented.

Emerging market funds increased 14.33%. Latin America has cheap labor, and returns are high there, as well as inflation and dividends being kept under control, said Ashwani Kaul, a senior markets analyst with Reuters Estimates.

Emerging markets, such as China, India and Brazil, have all had their economies built up very quickly and at some point it wouldn't be surprising if investors started to pull back a little, Roseen said. In regard to earnings, "everyone is expecting a blockbuster earnings season even though some companies are not posting high returns," Kaul said.

The S&P 500 earnings increased when the quarter first started. Current growth expectations have risen to 5.6%, compared to 4.9% when the quarter started. Once all companies report, Kaul believes the S&P will be up 8%.

The healthcare and technology sectors will most likely post the largest gains, 14% and 12% respectively. Technology is going to come back from a horrible 2006 as companies start to upgrade their spending. In fact, technology and healthcare will be the leaders this year, Kaul predicted.

Energy funds only managed a 4% gain, but declined 5% in the first quarter, Kaul pointed out. Cyclical consumer goods are also expected to show only a 1% gain due to oil prices and the weakening housing market, he said.

Revision trends across the board were favorable for the quarter. Except for three sectors, all have been revised favorably, which is a trend that has not been seen in over 4-1/2 years, Kaul said.

The three biggest negative revisions were cyclical consumer, lowered seven percentage points to minus 4%, and healthcare and technology, both revised down four percentage points to 14% and 12%, respectively. Positive revisions included energy, upgraded by nine percentage points to 5%, and financial services, advanced by four percentage points to 9%.

From an earnings standpoint, any time the market has declined over the year, it has rebounded at even higher levels, Kaul said. The 2008 and 2009 markets look good, he said.

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