Time to Revisit Micro-Cap Funds

Highly sensitive to the overall economy, the smallest firms have been hit hard recently by recessionary concerns. In turn, micro-cap funds have struggled. Nearly all have posted double-digits losses over the past year and investors have been voting with their feet. Most micro-cap funds have been in net redemptions since mid-2007, as fearful investors run for the exits.

But this recent slump has created a window of opportunity. Several top micro-cap funds have reopened their doors to new investors, including  Royce Micro-Cap (RYOTX) and  Wasatch Micro Cap Value (WAMVX). And we get the sense that more may follow suit. Of course, it's impossible to consistently get in at the bottom of any cycle, but investors taking a look at micro-caps now can rest assured that they aren't buying-in at the peak.

Small Package, Big Diversification
The main benefit of owning a micro-cap fund is diversification. It's one of only a few free lunches in the investing world: By combining uncorrelated asset classes you can lower risk and increase returns. Micro-cap stocks have richly rewarded investors over the long haul while having a relatively low correlation with the overall stock market. The most recent example was the last bear market from 2000 through 2002. That followed a mania for big technology and Internet firms that pushed the overall market to frothy multiples. Micro-caps largely avoided this problem. And during the bear market the CRSP Cap-Based Portfolio 10 Index--a capitalization-weighted benchmark of the smallest 10% of NYSE's listed equities--posted a cumulative 30% gain, compared with the S&P 500 Index's near 40% loss.

It doesn't take much. Placing just 5%-10% of a well-diversified portfolio in micro-caps can add a lot. For those on the fence, remember, you probably already have a dose of these tiny stocks. The average small-cap fund devotes a healthy 20% to micro-cap stocks, and even a large fund such as  Vanguard Total Stock Market Index (VTSMX) holds 2% in micro-caps.

What to Look For
Of course, you have to pick the right micro-cap fund, and that can be tough.

One of the biggest hurdles is finding a top fund that is open. For example,  Wasatch Micro Cap Value (WAMVX) slammed its doors shut just two days after its 2003 inception and only recently reopened.  Bridgeway Ultra-Small Company (BRUSX) closed its doors in 2001 with less than $60 million in assets and remains shuttered. There's also a limited set of options offered because these tiny funds aren't attractive businesses for many fund companies. They are volatile, and their cash flows have tended to follow suit, bringing an extra set of management challenges. And they're so tiny that they generate little revenue for their parent company.

On top of the standard due diligence when buying a fund, there are special considerations for micro-cap funds. First, pay close attention to costs and turnover rates. Many micro-cap funds charge egregiously high fees to make up for their small asset bases, and turnover tends to run high in this space. Asset bloat is also a concern with micro-cap funds. These funds mostly invest in stocks with market capitalizations of less than $500 million--the typical stock in the S&P 500 has a market cap of $50 billion--so a large asset base can easily make them unwieldy. Putting large amounts of cash to work in tiny companies can easily impact the share price or force a fund to increase its holdings. So, look for a history of the fund closing its doors early before assets grew too unwieldy.

The Short List
The limited number of investable options in the micro-cap space is disappointing, but here are a few bright spots to fill a small slot in your portfolio.

 Royce Micro-Cap (RYOTX)
Our first recommendation is this recently reopened fund. It has been around since 1991, making it an elder statesman among micro-caps funds. Veteran manager Whitney George has been in charge here since 2001, and the fund's record has been outstanding during his tenure. George's insistence on healthy balance sheets and an aversion to pricey stocks has helped the fund stay ahead of the pack. To mitigate risk George spreads his portfolio among 200 or so names and keeps turnover well below average. A peek at the fund's 2000-02 bear market performance highlights management's ability to keep a lid on risk. Our biggest concern with the fund is its size. At $901 million in assets, it is among the largest in the micro-cap space. But Royce is a shareholder-friendly shop with a track record of closing funds before performance is negatively impacted.

 Aegis Value (AVALX)
For value hounds, this fund is solid choice. It has a good long-term record and its manager has been in charge since the fund's 1998 inception. Lead manager Scott Barbee follows a deep-value approach inspired by Ben Graham, and this is reflected in the fund's low price/book and price/cash flow metrics. Barbee patiently waits for stocks to hit his value estimates, a big reason that the fund's turnover rate typically hovers near 20%. The fund slipped up from 2003 through 2005 but has since regained its footing. It has returned an average of nearly 13% annually since inception.

 Bridgeway Ultra-Small Company Market (BRSIX)
We recommend this fund for passive-aggressive types. The fund is distinct. For one, it tracks the growth-leaning CRSP Cap-Based Portfolio 10 Index. It keeps its expenses significantly below other micro-cap funds, and its advisor donates part of its profits to charity. Owing to its index approach, the fund has a turnover rate well below micro-cap peers. This strategy has been successful. Since its 1997 inception this fund has returned an average of 15.6% annually, crushing nearly every other micro-cap fund. As a bonus, lead manager John Montgomery rebalances less frequently than the index and uses proprietary trading techniques to keep the tax man at bay, making this a nice fit in taxable accounts.