Bitcoin funds won the third quarter, and bond funds lost-even as stocks kept going up.
Bonds are a portfolio's ballast, but their bête noire is rising interest rates, which have surged because of inflation from the Iran war and years of deficit spending. The $399 billion Vanguard Total Bond Market exchange-traded fund fell 3.4% in the quarter, just edging out the 3.5% average fund loss in Morningstar's intermediate core bond category. High rates and inflation are usually bad for stocks, too, although the S&P 500 index was up 2.3%.
Inflation at 3.4% isn't as bad as it was in 2022, yet the 10-year Treasury note yield recently crossed 5%, a level it hasn't seen since 2007. Meanwhile, 30-year mortgage debt rates have topped 7%, a rate which hasn't been typical since the 1990s, other than a few blips. Maybe the 1990s' dot-com bubble is instructive-high rates alone didn't stop that stock market freight train, either. Earnings misses, accounting scandals, a terrorist attack, and bankruptcies did.
Still, mortgage debt issuers with high credit quality are guaranteeing an annual return of 7%, and existing bonds that were issued at lower rates in the past are being sold off. The average fund in Morningstar's government mortgage-backed bond category fell 4% in the quarter, and the iShares MBS ETF lost 4.2%. Meanwhile, long-term bond funds, which are the most sensitive to rates, fell 6.9%. Interestingly, tax-free municipal bond funds fell more than traditional ones, in part because of excessive issuance.
Despite the poor performance, investors continued to add new money to bond funds in July and August, especially the intermediate core category, which saw $26.6 billion in new inflows, and the Vanguard Total Bond Market fund, which took in $5.8 billion. (September asset-flow numbers aren't available yet.)
After having a strong first half of 2026, small-cap funds of every category fell in the third quarter, the worst being small growth funds, down 9.6% on average. Historically, small companies, still early in their life cycle, are more dependent on debt financing to grow, so rising rates hurt them more than large well-established companies. The largest small-cap ETF, the $103 billion iShares Core S&P Small-Cap, declined 8% in the quarter after surging almost 20% in the previous one.
The worst-performing fund category in the quarter was utilities, down 11.6% on average. That's understandable, as utilities have bondlike dividend yields. But utilities are also the backbone of the artificial-intelligence data-center buildout, which requires massive amounts of energy. Virtus Reaves Utilities, which has an AI focus, had a bad quarter, down 13.9%. This could be either a buying opportunity for this fund or a warning sign for AI generally, depending on one's outlook.
There are also some interesting shifts in market leadership. While the average large blend fund was up 1%, and large growth, 1.2%, tech stock funds were down 2%, and healthcare ones were up 4.4%. Though the average large blend fund has a hefty 35% tech weighting, it also has 10% in healthcare stocks.
After years of being dead money, Big Pharma stocks like Merck and Johnson & Johnson came back strongly in the quarter. Merck was up 13.7% because of promising results for a new cancer vaccine that it partnered with Moderna to develop. The share price for Moderna, which collapsed after Covid ended and more recently because of the current political administration's hostility toward mRNA vaccines, soared 175%.
Yet the biggest winners by far were funds that invest in cryptocurrencies like Bitcoin. The $67 billion iShares Bitcoin Trust ETF was up 42.8%. The digital-assets fund category overall has behaved like a yo-yo in 2026, with the iShares ETF still down 4.3% year to date. Despite the failure of the crypto-friendly Clarity Act to pass, crypto still rallied because President Donald Trump?aligned regulators such as the Securities and Exchange Commission and the Commodity Futures Trading Commission stepped in with their own crypto-positive rule making. The fact that the Trump family has financial interests tied up with crypto doesn't hurt.
This shift hasn't gone unnoticed. During the quarter's first two months, healthcare funds received $3.8 billion in new investor money, reversing a negative trend in 2026. Though strong for the year, tech funds actually saw $3.1 billion in outflows in August.
Also strong were commodities, particularly anything energy-related, because of the Iran war. The $1.7 billion United States Oil fund, which invests in oil futures, was up 37.9% in the quarter and has surged 111% so far this year, with oil having recently crossed $100 a barrel. The $40 billion State Street Energy Select Sector SPDR ETF, which has 24% of its portfolio invested in ExxonMobil Holdings, gained 16.3%. Diversified commodity broad basket funds gained 14.6% on average.
Continuing its crazy run, the $190 million Breakwave Tanker Shipping ETF was the best-performing fund in the third quarter, surging 423% and up 4,001% for the year. It's the closest thing to a direct bet on the Iran war continuing as it invests in derivatives on crude-oil tanker freight rates. Since the Strait of Hormuz became perilous to navigate, freight rates have exploded.
Although they started the quarter strong, gold bullion and gold miner stock funds gave back some of their gains toward the end as the dollar strengthened on rising interest rates and amid an increased appetite for higher-yielding U.S. bonds. Investors may be on to something.
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