Ferreting Out Worthy Small-Value Funds
How to locate winners in a category with no Analyst Picks.
Our Picks
For some time, Morningstar's mutual fund analysts have had a tough time finding multiple small-cap growth funds that they felt belonged on our Analyst Picks list. Most of the funds with good historical records and stable management are closed to new investors, have moved up into mid-cap growth territory, or have bloated asset bases--and some have all three problems. That's why we now have only one pick in the small-growth category, Vanguard Explorer. We're now finding it all but impossible to identify small-value funds that are worthy of our Analyst Picks list. In February 2004, we dropped Ariel Fund (ARGFX) from our small-value picks because it was leaning so heavily toward mid-caps, and manager John Rogers was finding few small caps to purchase. We picked Royce Special Equity (RYSEX) in early 2003, only to see it close a couple of months later. At the beginning of this month, we removed Gabelli Small Cap Growth (GABSX) from the list because despite gaining assets, its expense ratio remained too high. Simultaneously, we dropped Royce Total Return (RYTRX) because it ballooned to $3.4 billion in assets. And finally, FPA Capital will soon wave goodbye to its Analyst Pick status, since it closes to new investors on July 9, 2004. That leaves us with no picks in the small-value category. Our inability to find truly fantastic funds that we feel worthy of our list shouldn't be seen as a sign that we think you should avoid the category. Perish the thought. Those happy investors in stellar but now-closed funds should continue to hold and/or keep investing in them per their asset allocation plans (unless the fund has closed to all investments, of course). But what about investors who lack small-value exposure? Should they simply avoid the area for now? We think not. Even though small-value funds have had a great run, most investors would be better off finding a solid fund that for one reason or another doesn't quite meet our Analyst Picks criteria, rather than ignoring that area of the stock universe in their asset allocation plan. Searching for a reasonable option with the Premium Fund Screener is fairly easy and straightforward. First, we'll look for funds in the small-value category, and then to make sure that the fund hasn't graduated to mid-caps, we'll stipulate that the equity style box indicates a small-cap style. Next, we'll weed out multiple share classes by selecting distinct portfolios only, plus we'll eliminate funds that are closed to new investments. That basically sets the stage. As far as small-cap funds are concerned, you'll generally want to look for low expenses, a solid record, and management stability. So we'll ask to see only those funds with below-average expense ratios in the category. There's a variety of ways to look for a decent record. In our screen--one easily modified--we'll ask to see those funds that have finished in the top half of the category over the volatile three-year period or that have finished in the category's top third over the longer five-year period. Finally, to ensure that most of the fund's record is on the current manager's watch, we'll demand a manager tenure of at least three years. To run this screen for yourself, click here. As of July 9, this screen yields 18 funds. Obviously there are plenty of contenders. A number of them are worthy options that just miss our Analyst Picks list for one reason or another. We'll highlight three of them. Constellation Clover Small Cap Value
Previously known as Turner Small Cap Value, this fund uses top-down economic expectations to allocate assets to the sectors and industries that managers Lawrence Creatura and Mike Jones believe are poised to outperform. That's tough to do with complete consistency, as the fund's record shows. While the fund's cyclical tilt did quite well in 2003 and has done very well so far in 2004, the managers made the move to economically sensitive stocks way too early in 2002, causing a nasty 21% drop that year. But over the long term, the fund has shined. We liked the fund a bit better when it had a smaller asset base and was able to own more micro caps, but it is still a nice option for patient investors. Tocqueville Small Cap Value
This bold little number looks for downtrodden fare with catalysts for growth. As with Constellation Clover, that means significant sector bets most of the time. Adding to the fund's high volatility, its portfolio is pretty compact with only about 40 holdings. When its favored areas have leapt back to life, as in 1999 and 2003, the fund has posted super returns. When catalysts haven't kicked in, though, the fund's relative returns have languished, as they did from 2000 through 2002. For patient investors, however, the fund has been a solid long-term holding. JP Morgan UM Behavioral Value (UBVLX)
With one key caveat, this fund is our favorite of the bunch. Because it tightly hugs the line between value and core stocks, it sometimes--as now--has fallen into small-blend territory. For those investors who don't mind that slightly unconventional style profile, it is a hidden gem. Manager Brendan MacMillan uses behavioral finance theory, which holds that investors often overreact to bad news, to troll for hidden bargains. He buys them and waits, sometimes for years, for them to return to favor. While the fund's bravery causes significant volatility, its returns have compensated strongly. It now sits in or very near the small-value category's top quartile over the one-, three-, and five-year trailing periods.
Previously known as Turner Small Cap Value, this fund uses top-down economic expectations to allocate assets to the sectors and industries that managers Lawrence Creatura and Mike Jones believe are poised to outperform. That's tough to do with complete consistency, as the fund's record shows. While the fund's cyclical tilt did quite well in 2003 and has done very well so far in 2004, the managers made the move to economically sensitive stocks way too early in 2002, causing a nasty 21% drop that year. But over the long term, the fund has shined. We liked the fund a bit better when it had a smaller asset base and was able to own more micro caps, but it is still a nice option for patient investors. Tocqueville Small Cap Value
This bold little number looks for downtrodden fare with catalysts for growth. As with Constellation Clover, that means significant sector bets most of the time. Adding to the fund's high volatility, its portfolio is pretty compact with only about 40 holdings. When its favored areas have leapt back to life, as in 1999 and 2003, the fund has posted super returns. When catalysts haven't kicked in, though, the fund's relative returns have languished, as they did from 2000 through 2002. For patient investors, however, the fund has been a solid long-term holding. JP Morgan UM Behavioral Value (UBVLX)
With one key caveat, this fund is our favorite of the bunch. Because it tightly hugs the line between value and core stocks, it sometimes--as now--has fallen into small-blend territory. For those investors who don't mind that slightly unconventional style profile, it is a hidden gem. Manager Brendan MacMillan uses behavioral finance theory, which holds that investors often overreact to bad news, to troll for hidden bargains. He buys them and waits, sometimes for years, for them to return to favor. While the fund's bravery causes significant volatility, its returns have compensated strongly. It now sits in or very near the small-value category's top quartile over the one-, three-, and five-year trailing periods.