For Micro-Caps, Go Active or Go Home

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.

 Berwyn 
Lead managers Robert Killen and Lee Grout subscribe to a value-oriented approach. Specifically, they seek competitively advantaged firms with healthy balance sheets and free cash flows and aim to buy these firms' shares when short-term considerations or a lack of interest from Wall Street make them available at a discount. Due to that valuation consciousness and management's emphasis on financially healthy firms, the fund's has an average Morningstar risk rating, even though the portfolio has fewer than 40 holdings and almost 60% of its assets in micro-cap names. With an experienced management team at the helm, this fund boasts a solid long-term track record while providing notable downside protection in bear markets. For a worthy diversifier to a portfolio anchored in blue chips, this offering looks to be a good bet.

 Perritt Micro Cap Opportunities (PRCGX)
With his portfolio sporting an average market cap just more than $230 million, manager Michael Corbett demonstrates an affinity for the tiniest companies. He prefers firms that are sitting on a lot of cash and offer compelling growth prospects, and he considers it a plus when management buys back its stock if the firm is trading at a discount. True, the fund's focus on ultrasmall firms courts risks when investors demand liquidity and flee for safety: The fund lost an annualized 51% in the last bear market. But it has made a fierce comeback since then, and the fund's record during Corbett's nearly 12-year tenure indicates that it's no one-trick pony.

 Royce Opportunity Investment (RYPNX)
As the fund's high risk rating suggests, lead manager Buzz Zaino takes a decidedly aggressive approach in his micro-cap stock selections. He is not shy about picking up firms with less-than-perfect financials as long as they fit into one of four categories: undervalued asset plays, turnaround stories, undervalued growth, and interrupted earnings (or busted IPOs). Firms must meet valuation criteria based on P/E or price/sales ratios, as well. Despite the fund's volatility, Zaino has proved his stripes as a talented stock-picker and has delivered a standout long-term record. For investors with long time horizons and the ability to handle volatility, this fund is a compelling diversifier.