NEW YORK -- Take a breath.
After delivering solid and consistent returns through the first half of this year, most types of mutual funds faltered in the third quarter. It wasn't a disaster -- most of the declines were modest, and the largest categories of stock and bond funds were virtually flat -- but it was a letdown for anyone who got accustomed to steady and widespread quarterly gains.
Of the 105 mutual fund categories that Morningstar tracks, 76 fell from July through September. Compare that with the prior quarter, when only six categories declined, and those were mostly niche funds that few investors own.
Here's a look at the trends that moved the markets:
Small-cap stock funds
The third quarter marked a return to earth for funds that specialize in stocks of smaller companies. Funds investing in a mix of small-cap growth and value stocks fell an average 6.8 percent.
Last year, those same funds were stars, returning an average 37.4 percent. At the time, investors were snapping up smaller companies on expectations that their earnings would grow faster than those of big companies.
But their popularity caused problems. Stock prices of smaller companies rose more quickly than their earnings, enough for investors to worry that small-cap stocks had become too expensive. The Standard & Poor's 600 index of small-cap stocks began the third quarter trading at 22 times its earnings per share, for example. That was well above its average price-earnings ratio of 17 over the last decade. By the end of the third quarter, the index's P/E ratio was down to 20.
Large-cap stock funds
Large-cap blend funds hold more assets than any other fund category. They own a mix of the biggest companies, such as Apple (Nasdaq: AAPL), Exxon Mobil (NYSE: XOM) and Google (Nasdaq: GOOG), and were virtually unchanged over the quarter. They ticked lower by an average of 0.1 percent, a big step down from the 6.4 percent return that they delivered in the first half of the year.
Many large-cap blend funds benchmark themselves against the S&P 500, which wobbled up and down through the quarter. Good news for them: The index set a record high on Sept. 18. Bad news: A late-September stumble surrendered most of the gains. The index returned 1.1 percent during the quarter, including dividends, its weakest return since the last quarter of 2012. That's when economists were warning that hikes in income tax rates and cuts in government spending would send the economy off a “fiscal cliff,” unless Congress made changes.
The mutual funds that form the core of most investors' bond portfolios, intermediate-term bond funds, were essentially flat last quarter. They lost an average 0.1 percent.
It's a letdown from the first half of the year, when intermediate-term bond funds returned 4.1 percent. All of the other 31 categories of bond funds tracked by Morningstar also registered gains in the year's first six months, benefiting from an unexpected drop in interest rates. When rates are falling, it causes the price of existing bonds to go up as their yields suddenly look more attractive.
Recent strengthening in the job market means economists expect the Federal Reserve to begin hiking its key short-term interest rate target sometime next year. The central bank is also on track to halt its bond-buying stimulus program later this month. That's raised expectations for interest rates to begin rising, at least slowly, which would act as a drag on bond returns.
Specialized stock funds
Indian stock funds were stars last quarter, as they've been since the election of a new prime minister in May. Investors expect Narendra Modi to push through reforms to tame India's high inflation and thicket of bureaucracy, and the country's stock market has soared in response.
Indian stock funds returned 5.5 percent last quarter. They're up 35.1 percent this year, helping them to make up their sharp losses in two of the last three years. Indian stock funds are bit players in the mutual-fund world, controlling a total of $7 billion in total assets. That's less than 2 percent of the $438 billion in diversified emerging-market stock funds, which spread their investments across India and other countries, including China and Brazil.
Health care stock funds were also winners, returning an average 4.6 percent. It continues a yearslong trend, as health care stocks have shaken off worries that the Affordable Care Act would hurt their earnings. Health care stock funds have returned an annualized 20.7 percent over the last five years. No fund category has returned more.
All 10 mutual funds with the worst returns focus on gold stocks. Low inflation and expectations for rising interest rates usually mean investors sell gold, and its price fell earlier this month to its lowest level since Jan. 2.