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Small Bases Not Holding Back These Medalist Funds

Mon, 4 Nov 2013

Morningstar's Russ Kinnel profiles three Bronze-rated funds that manage to do a lot with a little.

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Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. When it comes to mutual funds, good things can come in small packages. Joining me to discuss three hidden-gem mutual funds is Russ Kinnel. He's director of fund research for Morningstar.

Russ, thank you so much for being her.

Russ Kinnel: Good to be here.

Benz: Russ, to start out let's talk about why being small can be an advantage for mutual funds. Why do you sometimes want to look for those nimble funds with pretty small asset bases?

Kinnel: Well, it means the managers have maximum flexibility to invest the way they want. They can invest in as few stocks as they want. They can go down in market cap. If you look back at some of the best equity funds, you'll often see in their early days they may have had some of their very best returns.

Benz: Are there categories where you think being small tends to matter more and categories where maybe it isn't as big an advantage?

Kinnel: I would say equities in general rather than say bonds.

Benz: Why is that, by the way?

Kinnel: Bonds, outside of high yield, won't have a lot of liquidity issues.

Benz: So, they're very liquid.

Kinnel: Yes, and generally bond funds you run with caution in mind, and so it's not like you'd want to have an 8% stake in a single-issuer bond, whereas in equities you might because you want that upside.

Benz: So, equity funds to start, and then within equities, are there any certain categories?

Kinnel: Smaller-cap naturally or multicap; just something where you have more flexibility. For a more focused fund, it might matter a little more. It would matter less for, say, a very diversified large-cap fund, but for more focused or smaller-cap funds, that small asset base can really be an advantage.

Benz: So, the idea from a logistical standpoint is that the manager--because he or she isn't buying a huge number of shares of, say, a small-cap stock--is not going to move the price of that stock as they buy and sell. Are there any other advantages?

Kinnel: That's right. There are lower trading costs, but there's also just the greater flexibility. As you see a fund get more assets, you'll often see them move up in cap; they might have more positions in order to manage that liquidity. But a small fund doesn't have to make those compromises. They can really just look for the best opportunities and invest as they see fit.

Benz: Any disadvantages that you'd note when it comes to sort of very small asset bases?

Kinnel: The biggest one, I would say, is cost because small asset-base expenses tend to be a little higher.

A sneaky one is some of these funds are a little more likely to be killed off. At some point the fund company might give up on them; they might merge them away.

And then I would say the third thing is these are often funds that have relatively short track records, and that's why they're small.

Benz: Let's dive right into this list. You brought three funds to talk about; the first is Virtus Global Opportunities. It's a global-stock fund, and you think that it's actually quite a good pick, even though its asset base is quite small and hasn't attracted much attention yet.

Kinnel: That's right. The story on this is that Virtus bought the fund in 2009, so the record before then doesn't really matter. In this case, comanagers Rajiv Jain and Matt Benkendorf took the fund over then and they've done a good job at this fund, just as they have with longer track records at other Virtus funds. What's different here versus their other funds is this is global, so you're getting U.S. We know that they have a very good track record with foreign equities, and so it's the U.S. part that's a little unproven. But still you have a small asset base, very good managers, and a good conservative strategy.

Benz: In terms of how it typically will apportion its assets among U.S. versus foreign stocks, have you seen any patterns there?

Kinnel: It's really a little early to tell, but it seems like they're going for a fairly even mix. I don't think we're going to see really big swings, but it's still a little early.

Benz: [Morningstar fund analysts give the fund an Analyst Rating of] Bronze. Why not at that sort of highest level of conviction, maybe a Silver or even a Gold rating?

Kinnel: I think mainly because we want to see how they do with domestic stocks. We only are three-and-a-half years in to see how they do with domestic stocks. And then expenses are high. I think, if we saw expenses a lot lower, that would help the case. So, there's definitely a trade-off there that you're getting some good management with a lot of flexibility, but you're paying a little more.

Benz: The next pick, that's Royce Special Equity Multi-Cap. I think when a lot of people here Royce, me included, you think small-cap. So this fund is a little bit different from some of its peers, in that it doesn't focus exclusively in that small and mid-cap range.

Kinnel: Yes, this is run by Charlie Dreifus, who runs Royce Special Equity, which is a closed small-value fund.

Benz: One of our Fund Managers of the Year in the past.

Kinnel: He is one of our Fund Managers of the Year. He's just a brilliant investors who's very conservative, kind of an accounting geek, and he really looks for clean balance sheets and companies that are not doing any accounting gimmicks. This fund was launched a little less than three years ago to invest in a wider market cap.

So, the basic idea is the same: a focused portfolio of companies with clean accounting and stocks that are cheap. So far it's done quite well. It seems like Charlie Dreifus has been able to take a small-cap strategy and make it work for larger caps. That's typical of what you see with these smaller funds, in that you had a manager who was really good somewhere else and now they're adapting that strategy to a slightly different universe, It takes bit of a leap of faith, but I feel pretty good about a fund like this. I also like the fact that it's a conservative fund at a time when stocks have already had a good run.

Benz: Small caps especially. I guess one thing I wanted to ask you about, Russ, is that you noted that Royce Special Equity is closed. So, does this fund own the same small-cap stocks that appear in Special Equity, or to the extent that it owns small-cap stocks, does it own different ones?

Kinnel: Yes, there is some overlap. It's got some of the same ones, but then it's also got a lot of mid- and large-cap names, as well. As the name implies, it really is multi-cap. So, it's still got some small cap, but I think you're really investing in it here for what Charlie Dreifus can do with mid- and large-cap names.

Benz: The last fund we wanted to talk about is ASTON/River Road Select Value; another proven management team here, correct?

Kinnel: That's right. This is the same group that runs their small-value fund, and here they're just moving up slightly to kind of small- and mid-. They still even have some micro-cap names in the portfolio, but it's still a very small fund. It's got a little longer track record than the other two. The last few years it's actually not that strong a track record, but it doesn't bother me too much because I think of it as a conservative strategy. And the last few years have been a pretty strong bull market. But if you look at what it did in 2008 and 2011, you can see this is a good fund that still can protect on the downside.

Benz: So, we've got it in our small-blend category. Do you think of it as sort of a core-type small-cap vehicle, or should people think of it as being a multicap vehicle?

Kinnel: I think it's got some mid-caps, too, but I think, yeah, it's still kind of a core small-cap fund. But I think it's a really well-run fund. Again, I think that small asset base really gives them the flexibility, and with the mediocre track record so far, people probably aren't going to be rushing in.

Benz: Russ, thank you so much for sharing this list. I know that to the extent that investors are interested in actively managed funds these days, they really are looking at some of these more nimble types of funds. Thanks for sharing.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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