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For Micro-Caps, Go Active or Go Home

If you want access to the micro-cap sector, it's worth paying up for these active funds.

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While mutual funds and exchange-traded funds have long been pitted as rivals competing for investor dollars, there are times when one demonstrates a clear advantage over the other. In a recent video interview, Morningstar analysts Paul Justice and Sam Lee noted that mutual funds--rather than ETFs--offer safer and more profitable exposure to micro-cap stocks.

Micro-caps are less liquid than large-cap stocks, and that can lead to wide bid-ask spreads on ETFs that invest in them. Because ETFs aim to track their benchmarks without concern for the price they pay to execute their trades, they have high trading costs, and that, in turn, has led to poor risk/return profiles for micro-cap ETFs. As Sam Lee notes in this article, delegating the micro-cap portion of a portfolio to an active manager has paid off. Despite the fact that mutual funds sport significantly higher expense hurdles, 22 of 23 micro-cap funds with at least three years of history beat the average micro-cap ETF.

So what are the best micro-cap mutual funds? To home in on worthy micro-cap offerings that are readily available to do-it-yourself investors, we used our  Premium Fund Screener tool. We screened our domestic-equity universe for distinct portfolios of funds, eliminated load offerings, and set the average market-cap criteria to $738.81 million or lower--currently the upper limit for inclusion in Morningstar's micro-cap stock universe. (Of the 5,000 largest domestic stocks in our equities database, the top 1% are categorized as giant, the next 4% are large, the next 15% are mid, the next 30% are small, and the remaining 50% are micro. Stocks outside of the largest 5,000 are also classified as micro.)

To keep fees as competitive as possible, we screened for offerings with expense ratios lower than the category average. We also required that managers have helmed their funds for more than five years. Finally, we eliminated institutional funds as well as offerings with minimum purchase requirements of greater than $10,000. Premium members can  click here to replicate this screen. We highlight three of our findings below.

Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.