Though these small-cap funds' three-year records aren't terribly inspiring, the offerings' outperformance is a reflection of long-term strength.
The market conditions of the past three years have whipsawed small-cap funds in a big way.
From the Russell 2000's peak on July 13, 2007, to the market bottom on March 9, 2009, the typical small-cap fund shed 41%, whereas the typical mid- and large-cap funds shed 39% and 37%, respectively. From that bottom through the most recent peak on April 27, the typical small-cap fund surged by 89%, which outpaced its mid- and large-cap counterparts by several percentage points.
Those swings have wreaked havoc with small-cap funds' three-year record. The typical small-cap fund shed 5.7% annualized in the three years ending Aug. 16. That said, the challenge of navigating these turbulent markets was a virtual stress test that, when paired with longer-term performance periods, showed which funds lived up to their reputations and records during the crisis. Combining three- and 10-year results with other factors can help point to some interesting small-cap funds.
For this screen, we use Morningstar Principia to zero in on domestic small-cap funds with below-average expense ratios (below 1.3%) that are open to new investments of $25,000 or less.
Special Criteria = Distinct Portfolios Only
And ( Morningstar category = Small Value
Or Morningstar category = Small Blend
Or Morningstar categroy = Small Growth )
And Audited expense ratio < 1.30
And Purchase Contraints = Closed-New Investment
And Min Initial Purchase < 25,000
And Analysis not= NA
To stress-test the funds' records, look for options with three- and 10-year category rankings that are in the top quartile, and make sure the current manager has been around for at least 10 years.
And % Rank Cat 3 Yr < 25
And % Rank Cat 10 Yr < 25
And Manager Tenure (Longest) > 10
We ran the screen on Aug. 19. Here are a few funds that stood out:
Brown Capital Management Small Company
This is one of a handful of small-cap funds to eke out a gain during the trailing three years. (It rose 1.6% annualized.) That's because its 30% loss in 2008 and 46% gain in 2009 were far better than most peers' showings. Longtime manager Keith Lee and his team search for small-cap firms with durable competitive advantages and sound balance sheets. This helped the fund hold up better than most as the markets plunged in 2008. Some excellent stock picks such as business software firm Rovi
It's important for growth managers to understand competitive advantages well, because they're often paying hefty sums of money for current or past earnings, so losses could be big if future profits don't pan out. For example, the fund's second-largest holding, Green Mountain Coffee Roasters
Holding firms with such high earnings multiples means this fund will court its share of volatility, even when its calls are ultimately right. Although its 30% loss in 2008 was tame in relative terms, it also clocked a 40% decline in 2002 when investors were fleeing growth stocks in droves. Altogether, though, this fund can add some zip to a portfolio, taken in moderation and with patience.
Royce Special Equity
Would-be investors need to be prepared for the cash and high-quality focus to result in some streaky relative returns. That has been a problem here in the past. After the 2000-02 bear market, the fund was flooded with new investors, who then headed for the exits when it went on to post bottom-decile rankings for three consecutive years. But this fund has proved that defending capital during the gloomy times can have a great long-term impact. During the past decade, its 12% annualized gains bested the typical peer's by 2 percentage points.
In the end, conservative and patient types have plenty to like here.
Wasatch Small Cap Growth
Not so this time around. The fund got an extra kick from its roughly 17% stake in foreign small caps including GlaxoSmithKline Consumer Healthcare Ltd. of India--Cardon thinks India's rising population and the upward mobility of some of its lower classes should continue driving growth in the stock for years to come. It has already given the fund a boost and is one of the fund's better performers in 2010 as some domestic stocks have struggled. While the fund shed 2% on an annualized basis during the past three years (still better than nearly 90% of its peers), Cardon's approach has resulted in a 5% annualized gain over the past 10 years, which outpaced its small-growth peers by a wide margin.
Cardon searches for the best high-quality growth companies, often owning stocks for years, as has been the case with Hibbett Sports
Karin Anderson is a mutual fund analyst with Morningstar.