Before the Dow crossed the 10,000 mark one October afternoon, mutual fund investors remained split over where the economy was headed. In the third quarter, skeptics shoveled money into high-quality bonds, which for once didn't mean giving up returns. Optimists, on the other hand, pursued what many called a junk rally.

SAFETY WITHOUT SACRIFICE

Bonds were the bee's knees of the quarter, as investors drove $152 billion into the funds. Flows into bonds have been nearly doubling each quarter this year ever since they bled $30 billion in the fourth quarter of 2008, says Vincent Deluard, global equity strategist at Trim Tabs.

A majority of the dollars flooding in went to short-term government bonds, as nine of the top 20 largest fixed-income funds, in terms of assets, were intermediate term. Their performance, however, did not follow suit: the category was up a measly 1.3% and accounted for 85% of the 20 worst-performing fixed-income funds.

Though typically considered a safe play, high returns meant bond investors didn't have to sacrifice returns for comfort. "Your average bond fund is up 16% for the year with almost no volatility," Deluard notes. "So investors saw equity-like returns and what seemed like bond-like volatility."

But unlike previous quarters, flows into bonds were up across the board, as a plethora of new dollars poured into corporates, municipals and Treasuries. Even much riskier high-yield bonds saw significant inflows in the third quarter. In fact, high-yield bonds accounted for 70% of the top 20 performing fixed-income funds.

TAKING ON THE MARKET

But investors' focus on high yield bonds was only a part of the rush toward leverage. Real estate, the solar plexus of the recent recession, plowed ahead and is up 30% for the trailing three months ending Oct. 19. The sector's rise was mainly due to REITs, which have been able to save cash, since the government let them pay their dividends in shares this year. Nevertheless, many have slashed their dividends.

"They're financials, and anything with leverage has done really well lately," says John Coumarianos, a fund analyst at Morningstar. "REITs' balance sheets don't look lovely, but we've really seen a reversal from investors' take on leverage."

Small- and mid-cap equity funds outperformed their large-cap counterparts, much as they did after the 2001-2002 recession. But Coumarianos is hesitant to call this a junk rally, insisting that large caps have rallied too. "In a way you'd expect coming out of a brutal market to be led by more levered, small-cap companies," he says. Does this mean investors learned nothing last year? "It may," he concedes.

RISING NEIGHBORS

The success story in international markets this year continued, with global equity funds taking in $13.4 billion. Despite having three times the number of products, domestic equity funds saw only $3.6 billion in inflows. Emerging markets led the pack, with gangbuster Latin America up 41%. The news wasn't as good for Asian markets, however-particularly China-which finally saw a sell-off after a steady rise upward. Still, beleaguered Japanese funds were up only 8% for the quarter.

Should skeptics, then, be making their way out of the global market as the year ends? Deluard doubts it. "Going forward, they'll stay up. Even if you invest in European stocks and they don't beat the U.S. market, you'll still be making money because of such a weak dollar."

Click here for the quarterly mutual fund tables.