Beware the Small-Cap Effect

As you are no doubt aware, Morningstar divides the universe of diversified domestic-stock and foreign-stock funds into style-based categories to ensure that funds are being ranked against their true peers. Of course, within these categories there will be some diversity in style. For example, a fund's slightly greater attention to value or growth fare might help it beat some peers even within its narrowly focused category. But a large-growth fund won't come out near the top of a performance chart, say, just because growth has been hot. The fund is ranked only against other large-growth funds, so it doesn't get to stand atop all the value funds that didn't even have a chance.

In some categories, though, Morningstar does not divide the funds by style--usually because there aren't enough funds of different types to make up viable subcategories. We think this makes sense because having a style category with only five or six entrants would provide misleading information. As a result, within these non-style-specific categories you need to pay even more attention to whether style-based factors are driving their gains or losses.

Rising with the Small-Cap Tide
Right now, a key factor to keep in mind is the outperformance of small caps around the world. Take  FPA Crescent (FPACX) for instance. Through March 2, 2004, it has the best trailing three-year gain in the moderate-allocation category; its 19.2% return beats the category average by an amazing 17 percentage points. Don't get me wrong: This is an admirable fund with a talented manager, and the fact that it focuses on small caps isn't the only reason it has shone. (The makeup of its bond component, for example, has also helped.) Indeed, it's not the only offering in that category that buys smaller stocks, and it has beaten even those peers' impressive gains, so it deserves credit for its performance. But the fact that small caps (and in particular, the value-oriented small fry this fund prefers) have outpaced large caps in recent years does help explain why this fund has trounced its category's average. Most offerings in this group focus on blue-chip companies for their stock components. So don't buy FPA Crescent without recognizing that it won't perform nearly as well, relatively speaking, when small stocks--or a value style, for that matter--fall out of favor. In both 1998 and 1999, for example, when growth stocks led the way, this fund landed in the category's worst decile.

Small-cap-oriented funds have also looked like geniuses in our world-stock category, which--unlike the former foreign-stock category--has not been subdivided and still includes funds of all different styles and market caps. Currently two of the three funds at the top of the three-year rankings, Polaris Global Value (PGVFX) and  Templeton Global Smaller Companies (TEMGX), target small- and mid-cap stocks. The other top-ranked offering,  Oakmark Global (OAKGX), uses an all-cap strategy, and the portfolio currently features plenty of large firms. But for much of the period in question it had substantial small-cap exposure.

Note that all three of these world-stock funds use a value style. Even though technology firms and other growth stocks enjoyed a resurgence over the past 12 months, these funds' three-year returns amply illustrate the benefits of having owned value stocks during the bear market--and how value has kept pace even during the recent rally. Here again, if either small stocks or value or both get shoved to the rear, these chart-toppers almost certainly will find themselves lagging. Don't avoid them for that reason; just don't expect present trends to continue indefinitely.

Small Caps Reign in Japan
A final example makes the point even more emphatically. The typical Japan-stock fund is in the red over the trailing three-year period, posting a dismal 0.9% annualized loss. But two Japan funds have posted double-digit annualized gains in the same period. Not surprisingly, both focus on small caps:  Dimensional Japanese Small Company (DFJSX) and  Fidelity Japan Smaller Companies (FJSCX).

The Fidelity fund took in substantial inflows in 2003, which brings up another point. Investors have piled into small- and mid-cap funds, as well as emerging-markets offerings, over the past year, attracted by these groups' hot recent performance. But as Morningstar senior analyst William Rocco has noted in recent columns, investors who have just arrived in those groups could have unrealistic expectations. The same goes for the funds mentioned here.

There's no telling which parts of the market will rise or fall or beat the others. And current trends could continue for awhile. But ultimately, funds that have been helped to the top of their respective charts by their investment styles will suffer--even if that means simply not gaining nearly as much as large-cap or growth-focused counterparts--when the tide turns.