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By Laura Lallos | 08-07-2014 06:00 AM

Finding Opportunity in Small Cap Funds' Reversal of Fortune

A stretch of bad performance and outflows could offer an attractive chance to get into these top-rated funds.

Laura Lallos: Small-cap funds have had a dramatic reversal of fortune so far in 2014. These were the best performers among domestic diversified stock funds last year, and now they are the worst--particularly small-cap growth, which on average is down more than 3% through July.

As [Federal Reserve chair] Janet Yellen recently observed, speculative biotech and small-cap tech names may be overvalued after their great run last year, and we are seeing that shareholders are concerned. We're seeing outflows from these funds. In fact, one of the best funds in the category, Morgan Stanley Small Company Growth [which has a Morningstar Analyst Rating of Gold], is down more than 14%. This is a fund that is run by Dennis Lynch, who we named our Domestic-Stock Fund Manager of the Year last year. This short-term underperformance does not cause us to change our long-term view that this is an excellent holding for shareholders who can stick with it.

Some of the other best funds in the category are also seeing outflows. This may create opportunities, in fact, because many of the top-rated funds in the small-growth category closed to new investors after 2013's great run. So, that’s something people may want to watch.

For people who are interested in maybe getting in now, there are still some good names that are open to investors. Two Silver-rated funds come to mind. One is Conestoga Small Cap, and the other is LKCM Small Cap Equity. These are funds that take relatively conservative approaches to an aggressive area, and that may be attractive to investors who are thinking about getting in now. These funds may have farther to fall, but now might be a good time to dollar-cost average in.

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