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GMO Turns Negative on Small Caps

Plus, FDIC-insured 529 bill moves through U.S. Congress.

Morningstar Analysts, 05/03/2010

U.S. small-cap funds have been soaring. The average fund in Morningstar's small-cap blend category is up more than 55% over the past year through April 29. But these outsized returns aren't likely to continue, according to one prominent asset manager. That's because the recent run has made most small-cap stocks overvalued.

GMO, which has a successful track record in forecasting asset class values and their subsequent returns, now thinks U.S. small caps will return a negative 1.2% in real terms (registration required), which doesn't account for inflation, over the next seven years. It is the first time the firm has projected negative returns for the asset class since Dec. 31, 2007, when it forecast similar negative returns.

GMO derives its forecasts in part by assuming profit margins and price/earnings multiples for small caps will revert to historical levels over the next seven years. Because the firm thinks small caps are about 50% overpriced, they would have to fall about 1.2% a year in real terms over the next seven years to return to fair value.

GMO's forecasts have proved correct in the past. In December 1999, it projected small caps would return approximately 2.5% a year in real terms over the next decade before fees, transaction costs, and taxes. They ended up with a 2.3% annualized return.

FDIC-Insured 529 Bill Moves Through U.S. Congress
The House of Representatives recently passed a law that would create a new category of FDIC-insured 529 plans. The bill, known as the Deposit Restricted Qualified Tuition Program Act of 2010, would allow FDIC-insured savings accounts and certificates of deposits to be included in 529 plans for the first time.

The legislation is a reaction to the disappointment many college-savers voiced to their representatives after some "core" bond funds in various 529 plans experienced steep losses in 2008.

529 plans provide for tax-free growth of investments if used primarily for college-related educational expenses. Currently, most of the options under such plans carry no explicit government protection on their underlying investments.

The bill was passed without opposition and now moves to the Senate for consideration.

Oppenheimer Fires Manager of Flagship Large-Growth Fund
This week, Oppenheimer fired Marc Baylin, the manager of Oppenheimer Capital Appreciation OPTFX, and hired Julie Van Cleave as his replacement. Capital Appreciation is Oppenheimer's flagship large-growth fund with $6 billion in assets. It has shrunk in half since 2007.

Baylin's tenure at Oppenheimer Capital Appreciation, where he had been since October 2005, was middling up until 2008's bear market. Baylin originally comanaged the fund with Bill Wilby, who compiled a great record at Oppenheimer Global OPPAX. But Wilby retired in mid-2007. The next year the fund lost 46% and trailed 88% of its large-growth category peers.

Van Cleave previously comanaged DWS Capital Growth SDGAX from December 2002 to January 2009, during which time her fund had an above-average long-term record. Van Cleave's DWS fund lost 32% in 2008 year, which put the fund in the category's top 5%.

RiverSource Gets New Fixed-Income and Alternatives Leaders
RiverSource, a unit of Ameriprise Financial AMP, announced two new section chiefs in relation to the firm's planned acquisition of Columbia Management.

Colin Lundgren will become the firm's new head of fixed income. Lundgren, who is currently sector leader of institutional fixed income and asset allocation, will gradually be transitioning his portfolio-management responsibilities to other members of the fixed-income team.

The firm also announced that Todd White, the sector leader of liquid and structured assets, will become head of alternative and absolute-return investments for the combined organization.

Investor Appetite Keeps TIPS Ticking
Five months after many prominent Treasury Inflation-Protected Securities managers questioned the sustainability of the asset class' run, TIPS funds find themselves even higher thanks to growing investor interest.

Morningstar's inflation-protected bond category has seen inflows of more than $22 billion dollars over the past year, bringing the category's total to $77 billion. A year ago, the category had less than $50 billion in assets.

The category, which is up 9.6% over the last 12 months through April 29, has benefited from not only from strong asset inflows but also continued low inflation expectations. The yield on a 10-year TIPS before any inflation adjustment is currently 1.37%. That's up slightly from the 1.14% the bond yielded on Dec. 1 of last year.

Prudential Investments launched Prudential Jennison Market Neutral PJNAX. Managed by Jennison Associates, the long-short fund seeks consistent returns in both up and down markets. The fund's expense ratio is capped at 1.85% through June 30, 2011. Prudential Investments is the mutual fund family of Prudential Financial PRU.

Franklin New York Insured Tax-Free Income FRNYX will merge into Franklin New York Tax-Free Income FNYTX by August 2010.

Melissa Fond is off the portfolio-management team of American Century Small Company ASQAX and American Century NT Small Company ACLOX.

Hilary Roper joined Daniel Manion as comanager of Sentinel Common Stock SENCX.

Effective May 1, 2010, John Brynjolfsson, who previously served as a managing director of PIMCO and who now acts as CIO of Armored Wolf, will subadvise a portion of Alternative Strategies AASAX.

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