GO WHERE THE MONEY IS.

Sometimes a contrarian investment can pay off in the long run. Such is the case now with financial services mutual funds, which hold the stocks of banks, brokerage firms, insurers, and other financial companies. As of August, these funds had gone up less than 1% for the year. Investors would have been better off going to a bank and putting their money into a CD. But that's not the whole story behind these funds.

"A lot of people equate lower interest rates with higher earnings when it comes to financial stocks," says Laura Pavlenko Lutton, an analyst at mutual fund tracker Morningstar, but that hasn't been the case this year. Since the Federal Reserve has been raising interest rates and has signaled that it will continue to do so, financial stocks have lagged. As the Fed has moved to boost short-term interest rates, long-term interest rates have stayed unexpectedly low.

"Considering that oil is trading at over $60 a barrel, and the Federal Reserve has been raising rates, it's surprising to see the 10-year Treasury yielding around 4%," says Mike Blatt, a portfolio manager with Chemung Canal Trust Co. in Elmira, New York. The result is that banks are being forced to pay depositors higher yields on savings accounts, but they haven't been able to raise the interest rates that they charge on loans. This has squeezed the profit margins of banks, hurting their stocks. Banks such as Citigroup, Bank of America, and JPMorgan Chase are the largest holdings in this category of mutual funds, according to Morningstar.

The silver lining in all of this is that now, financial services mutual funds have the lowest price-to-earnings ratios, price-to-book values, and price-to-cash flow of all stock fund categories. Put plainly, these funds are cheap. Moreover, these funds have been great long-term performers. Over the last 10 years, they've returned nearly 14% per year, a record few other categories can match. To put that in perspective, if you had invested $10,000 in 1995 and it grew 14% each year, you would now have $37,000, despite the 2000-2002 bear market. "You can go back even further, to the past 30 years, and see that the financial services sector outperformed the broader market" says Raymond Stewart, chief investment officer at RASARA Strategies, an asset management firm in Briarcliff Manor, New York.

Since financial services mutual funds have already taken a hit, things could improve quickly. "It can be a mistake to equate low interest rates with higher earnings for all financial stocks," says Lutton. "Insurance companies go through cycles that may not correspond to interest rate movement. In addition, if interest rates move up from here, that may be a sign of a stronger economy, which would be helpful for the stock market and for brokerage firms. The financial services sector is more diverse than many people realize."

In fact, now might be the right time for financial services mutual funds. When the Fed stops raising interest rates, these stocks often outperform, and many observers think the current round of rate increases will come to an end in late 2005 or 2006.

Although investors shouldn't overload on financial services mutual funds, a fund in this category might merit a small place in a well-diversified portfolio. "Investors who have growth-heavy portfolios might use these funds for balance," says Lutton. That is, a financial services mutual fund that holds value stocks could steady a portfolio tilted too far toward growth stocks.

If you're interested in financial services mutual funds, a couple of Morningstar analyst picks are the Davis Financial (RPFGX) and T. Rowe Price Financial Services (PRISX) funds, both of which spread their holdings over many different types of companies.