Editor’s Note: MarketOwl is a totally free publication. We hope you find the commentary interesting, insightful and valuable. If so, please encourage your friends and acquaintances to sign up.

During the third quarter of 2006 the S&P 500 gained 5.7% while the average mutual fund gained just 2.5%, according to a recent Morningstar report. The fourth quarter is starting the same way with the broad indices rising sharply and most funds lagging. There are many reasons why it is difficult for fund managers to outperform the S&P 500 even over short periods.

For the past couple of years, the top-performing sectors of the market were oil and natural resource stocks (including precious metals). In general, fund managers who wanted any positive performance had to find a way to add these stocks to their portfolio mixes. Depending on the category of fund, that isn’t always possible. Some managers tried to enhance performance by overweighting their portfolios in those sectors.

In recent weeks we’ve seen a major shift in the economy. The energy and natural resource sectors have been pummeled while blue chip stocks rallied. This is forcing a lot of fund managers to realign their portfolios. They must sell the energy and natural resource stocks that have become a drag on performance. And they must try to decide what sectors are likely to perform best over the next couple of quarters so they can overweight portfolios in those areas.

The chart below shows a comparison of the Dow (black line) against energy (gold line) and gold over the past three months. It is clear to see that beginning in early August, these three investment vehicles have been moving in opposite directions. A fund manager holding energy or gold during this period must concern himself not just with the money he is losing in those positions, but with the money he could be making by holding something else.

None of this is easy. A look at the top-performing sectors over the past 30 days provides no clear cut market leaders. For example, some of those showing up include home builders, brokerages, transportation, retail, software, leisure, and biotech. When international markets are included, Latin America and emerging markets pop up high on the list. But while these sectors have done well over the past 30 days, there is no guarantee that they will be the leaders over the next 30, 60 or 90 days.

Consider the choices a fund manager must make. With virtually every market expert predicting a major downturn in real estate, is now the time to invest in home builders, even though they are a leader today? What about transportation? It is doing well now because the price of oil has fallen. Is that a long-term trend worthy of a significant financial gamble? Retail could perform well through the Christmas shopping season, but will that continue in January and February? These are the types of questions fund managers are concerned about right now as they try to reallocate portfolios to the up and coming sectors. And it is why many very good funds are trending sideways right now while the major averages are advancing.

While the Dow continues to make headlines for reaching new all-time highs, most investors probably aren’t aware that the Dow is no longer the strongest performing major index. The Nasdaq claimed that role in mid-September and relegated the Dow to runner-up status. On the chart below the Naadaq is the black line and the gold line is the Dow. It is plain to see that for the past five weeks, the Nasdaq has quietly been outperforming the Dow. It hasn’t gotten as much attention because it is nowhere near an all-time high.

Having the Nasdaq as the leading index is a very positive development for the markets. Historically, investors make their biggest gains when the Nasdaq is the dominant index. It is generally composed of smaller, riskier stocks than the Dow or the S&P 500. When the Nasdaq is advancing fastest, it means investors feel good about the economy and the markets. So don’t be surprised if many of these fund managers start loading up their portfolios with technology stocks that trade on the Nasdaq.

Have a great weekend and enjoy the beautiful fall weather.

F.S.