Buck the Trend and Stick with Strong Small-Cap Funds

If your friends jumped off a bridge, would you do it too?

It's been rough going for the markets since mid-July. Many indexes have recently reached "correction" status; that is, they've fallen 10% from their respective peaks. Financial stocks have been hit the hardest, but U.S. small-cap stocks certainly haven't had it easy. While the S&P 500 has fallen 8.36% since July 19, the Russell 2000 has dropped 12.75%. As the markets have been volatile, some investors have reacted: More than $5 billion has come out of small-cap funds in the second half of 2007.

We took a look at the small-cap funds that investors have been selling--and buying--since July. It should go without saying that what you, dear long-term investors, do with your small-cap funds depends largely on the rest of your portfolio. Small caps have been big winners over the past five or so years--if they've grown to be too large of a stake, it makes sense to trim your holdings. On the other hand, corrections can present opportunities. Should you succumb to peer pressure? Read on.

Investors Are Leaving These Small-Cap Funds
 Vanguard Small Cap Value Index (VISVX)
Atop the list of "most redeemed" funds since July is Vanguard Small Cap Value Index. It has seen net redemptions of roughly $340 million--not a huge number by mutual fund standards, but it does represent more than 5% of this big small-value fund's current total net assets. A big chunk, more than 30% of assets, sits in financial stocks, including loads of regional banks and REITs, so the fact that investors are pulling back here isn't surprising, given the problems and risks in those sectors. The fund has done a good job over the past four and a half years of tracking its index, the MSCI U.S. Small-Cap Value Index, however, and that bogy remains a good representation of the small-value corner of the market. And as financial stocks recover, this one's big concentration there will likely help it past its peers. If you have the stomach for some bumps, we'd hang on for the long haul.

 Managers Special Equity Managers (MGSEX)
This small-blend fund has seen more than 10% of its asset base redeemed since July. That level of defection is a bit surprising, considering the fund has actually held up pretty well during the recent downturn. But there are other issues here. While we like a number of the six subadvisors on this fund, a sprawling portfolio of more than 300 stocks dilutes the potency of any one of them. Its long-term returns have been only so-so. Combine that with a too-high expense ratio, and there's reason to seek better small-blend options.

 Royce Low-Priced Stock 
This one's a head-scratcher. Royce funds tend to perform well in tougher times, and this one has been no exception. And yet, despite the fact that it's closed, investors have been selling. More than $260 million has left the fund, roughly 5% of assets. Here, lead manager Whitney George continues to bet big on materials stocks, such as top holdings Silver Standard Resources (SSRI). George, however, also is worried about a general small-cap downturn, so he is also carrying a hefty midteens cash stake. For long-term investors, the fact that some shareholders are leaving is great--a smaller small-cap fund can more easily take advantage of opportunities. George and the team at Royce are experienced small-cap hands with great long-term records. There's no reason to sell this one.

 MainStay Small Cap Opportunities (MOPIX)
More than $225 million has left this small-value fund, and that's not a pittance for this $1 billion fund. The quantitative fund has been a huge disappointment in 2007, losing nearly 20% for the year to date--much of that in the third quarter. A hefty financials stake hasn't helped, but frankly, neither have the redemptions. Without much of a cash cushion, the fund likely has had to sell into weakness at times, as shareholders pull money out. There are other issues here, including new management, new models, and a big expense ratio. We don't blame shareholders for bailing.

 Third Avenue Small Cap Value (TASCX)
This one is another surprise. Shareholders have redeemed more than $170 million worth of this closed small-blend fund. Performance has been quite strong so far this year, including during the recent correction. It also remains one of our favorites--it's the only Fund Analyst Pick included in this article. Experienced manager Curtis Jensen uses a high-conviction, time-tested approach to small caps here; his long-term record is beautiful, particularly when you consider how stable the fund has been. Jensen tends to take advantage of corrections. If this fund reopens, investors ought to consider buying it while they can.

These Small-Cap Offerings Are Taking Money In
 Keeley Small Cap Value 
We can see what's attracting investors to this small-blend fund--an exceptional track record, complete with topnotch three-, five-, and 10-year returns. In fact, this fund has grown more than tenfold over the past three years (some of that's due to market returns). Manager John Keeley certainly deserves credit for an unusual investment strategy that focuses on corporate restructurings and merger and acquisition beneficiaries. (M&A has been abundant over the past several years.) We like Keeley, but investors looking for a repeat performance of midteens annualized returns in the near to intermediate future will likely be disappointed. No winning streak continues unabated.

 Royce Value Plus (RYVPX)
Maybe some of the money coming out of  Royce Low-Priced Stock  is going into small-growth Royce Value Plus. After all, market pundits have been calling for growth investing's return to favor for some time. We're more inclined to believe that investors are impressed with the fund's three- and five-year total returns. Don't get us wrong: The fund is impressive, and we respect Royce and its team tremendously when it comes to small caps. Here, lead manager Chip Skinner applies Royce's value approach to growth sectors. We can't fault investors for buying this conservative small-growth fund; however, it is among the more intrepid offerings at Royce. Those looking for a smooth ride in a potentially bumpy near term could be disappointed; long-term investors, however, have bought a good one.

 Oppenheimer Main Street Small Cap (OPMSX)
This quant fund hasn't held up well since the market peaked in mid-July. It has lost 14.5% between July 19 and Nov. 27, 2007. That's not at all surprising, because quantitative funds, which tend to work best as trends extend themselves, aren't strong during more-volatile times because their models don't always keep up with rapidly changing data points that serve as inputs. So it's curious that this fund is among the best sellers in the second half of 2007--it has brought in nearly $290 million. For the long term, it's an okay small-blend choice, giving investors broad exposure to the small-cap universe without taking on too much risk. Its returns have been adequate, but there are more-appealing choices.