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Buck the Trend and Stick with Strong Small-Cap Funds

Some of the most-redeemed small-cap offerings are long-term winners.

Bridget B. Hughes, 12/04/2007

If your friends jumped off a bridge, would you do it too?

It's been rough going for the markets since mid-July. Many indexes have recently reached "correction" status; that is, they've fallen 10% from their respective peaks. Financial stocks have been hit the hardest, but U.S. small-cap stocks certainly haven't had it easy. While the S&P 500 has fallen 8.36% since July 19, the Russell 2000 has dropped 12.75%. As the markets have been volatile, some investors have reacted: More than $5 billion has come out of small-cap funds in the second half of 2007.

We took a look at the small-cap funds that investors have been selling--and buying--since July. It should go without saying that what you, dear long-term investors, do with your small-cap funds depends largely on the rest of your portfolio. Small caps have been big winners over the past five or so years--if they've grown to be too large of a stake, it makes sense to trim your holdings. On the other hand, corrections can present opportunities. Should you succumb to peer pressure? Read on.

Investors Are Leaving These Small-Cap Funds
Vanguard Small Cap Value Index
Atop the list of "most redeemed" funds since July is Vanguard Small Cap Value Index. It has seen net redemptions of roughly $340 million--not a huge number by mutual fund standards, but it does represent more than 5% of this big small-value fund's current total net assets. A big chunk, more than 30% of assets, sits in financial stocks, including loads of regional banks and REITs, so the fact that investors are pulling back here isn't surprising, given the problems and risks in those sectors. The fund has done a good job over the past four and a half years of tracking its index, the MSCI U.S. Small-Cap Value Index, however, and that bogy remains a good representation of the small-value corner of the market. And as financial stocks recover, this one's big concentration there will likely help it past its peers. If you have the stomach for some bumps, we'd hang on for the long haul.

Managers Special Equity Managers MGSEX
This small-blend fund has seen more than 10% of its asset base redeemed since July. That level of defection is a bit surprising, considering the fund has actually held up pretty well during the recent downturn. But there are other issues here. While we like a number of the six subadvisors on this fund, a sprawling portfolio of more than 300 stocks dilutes the potency of any one of them. Its long-term returns have been only so-so. Combine that with a too-high expense ratio, and there's reason to seek better small-blend options.

Royce Low-Priced Stock RYLPX
This one's a head-scratcher. Royce funds tend to perform well in tougher times, and this one has been no exception. And yet, despite the fact that it's closed, investors have been selling. More than $260 million has left the fund, roughly 5% of assets. Here, lead manager Whitney George continues to bet big on materials stocks, such as top holdings Silver Standard Resources SSRI. George, however, also is worried about a general small-cap downturn, so he is also carrying a hefty midteens cash stake. For long-term investors, the fact that some shareholders are leaving is great--a smaller small-cap fund can more easily take advantage of opportunities. George and the team at Royce are experienced small-cap hands with great long-term records. There's no reason to sell this one.PAGEBREAK

MainStay Small Cap Opportunities MOPIX
More than $225 million has left this small-value fund, and that's not a pittance for this $1 billion fund. The quantitative fund has been a huge disappointment in 2007, losing nearly 20% for the year to date--much of that in the third quarter. A hefty financials stake hasn't helped, but frankly, neither have the redemptions. Without much of a cash cushion, the fund likely has had to sell into weakness at times, as shareholders pull money out. There are other issues here, including new management, new models, and a big expense ratio. We don't blame shareholders for bailing.

Third Avenue Small Cap Value TASCX
This one is another surprise. Shareholders have redeemed more than $170 million worth of this closed small-blend fund. Performance has been quite strong so far this year, including during the recent correction. It also remains one of our favorites--it's the only Fund Analyst Pick included in this article. Experienced manager Curtis Jensen uses a high-conviction, time-tested approach to small caps here; his long-term record is beautiful, particularly when you consider how stable the fund has been. Jensen tends to take advantage of corrections. If this fund reopens, investors ought to consider buying it while they can.

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