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Small-Cap Funds That Deliver a Smoother Ride

In a notoriously volatile arena, these quality funds offer lower risk than their peers.

These days it seems like many investors remain fearful of risk. The punishment of the 2008-09 market drop still on their minds, they've plowed assets into bond funds and sought refuge in alternative investments in an attempt to minimize the likelihood of losing their shirts should the market take another turn for the worse. That makes for a tough environment for small-cap funds, which invest in smaller-company stocks that sometimes outperform large caps but bring increased volatility along for the ride. In 2011 investors pulled about $7 billion out of small-cap funds, and as of the end of July they had pulled another $6 billion out so far this year. The fact that small caps have lagged large caps during that time period certainly plays a role, but investors' lack of appetite for volatility surely does, as well.

Among the many ratings Morningstar provides for funds is a proprietary metric called Morningstar Risk, which ranks funds relative to their peers based on downside volatility (potential losses are emphasized because it is presumed that investors won't mind if a fund tends to be volatile to the upside). The risk ratings are distributed as follows: high (the most risky 10%), above average (next 22.5%), average (middle 35%), below average (next 22.5%), or low (the least risky 10%), with lower ratings corresponding to lower risk and less volatility. Funds are rated over three-, five-, and 10-year time periods when possible. An overall rating (provided only for funds that have not changed categories) uses a weighted average of the given time period ratings. The Morningstar Risk measure also helps determine the Morningstar Rating for funds, commonly known as a fund's star rating. You can read more about this rating methodology by clicking here.

Although investors taught to equate risk with reward might expect higher-volatility funds to outperform those with lower volatility, in fact this increased volatility can have the opposite effect because of investor behavior. Those dramatic price swings can cause investors to move assets into and out of a fund more frequently than they would with a less volatile fund. As noted in an earlier Five-Star Investor article, investor return--what the average investor experiences with a fund--frequently lags a fund's total return, which often results from investors fleeing funds that experience steep drops and missing out an any rebound that might follow.

To find quality small-cap funds with reduced volatility we used Morningstar's
Premium Fund Screener tool and sought small-cap growth, small-cap value, and small-cap blend funds with below-average Morningstar Risk ratings and Gold, Silver, or Bronze Analyst Ratings. We screened out noninvestor classes, load funds, and funds that are currently closed. Of the funds on our screen, all were of the small-blend or small-growth categories. Premium users can see the full list here. Below is a sampling.

T. Rowe Price New Horizons (PRNHX)
Although most of this fund's sterling long-term performance record was achieved under a different manager, current manager Henry Ellenbogen, who took over in 2010 after a successful run managing T. Rowe Price Media & Telecommunications (PRMTX), has done nothing to tarnish it. The fund is among the top 1% of performers in the small-growth category for the trailing three-, five-, and 10-year periods. Ellenbogen's team looks for companies poised to become blue chips, with good business models, strong corporate cultures, and sound management. The fund's diversified portfolio of more than 200 stocks helps reduce volatility, as does its average market cap, which, at $2.2 billion, is double that of the Russell 2000 Growth Index. The fund invests in growing companies that cater to niche markets and with solid franchises. Top holdings include Regeneron Pharmaceuticals (REGN), Panera Bread , and O'Reilly Automotive (ORLY). The fund's 0.81% expense ratio is low for its category, especially for an actively managed fund.

Conestoga Small Cap (CCASX)
This relatively tiny fund, with just about $250 million in assets, has weathered recent market volatility better than many of its peers, in large part because of its emphasis on stable, high-quality companies. Managers Bill Martindale and Bob Mitchell have run the fund since its 2002 inception and adhere to strict quality measures, resulting in a portfolio of firms that tend to have low debt levels. The result is a fund that often outperforms on the downside but underperforms when markets are raging. Its five-year annualized return of 5.1% beats its small-growth peers by 2.8 points. The portfolio holds about 50 companies, with an overweighting (40%) in technology. Fees of 1.1% are below-average for its category.

Stratton Small-Cap Value (STSCX)
A lackluster recent showing (80th percentile in the small-blend category during the past year) belies this fund's strong long-term performance. Its 10% annualized return during the trailing 10-year period places it in the top 15th percentile versus its peer group. Manager Gerald Van Horn, who has been at the helm since 2000, uses the fund's longtime cash-flow-based quantitative model and prefers companies in rising industries or that are undergoing restructuring. The fund has a low 16% turnover rate and holds about 60 stocks, with an average market cap of about $2 billion. Holdings are spread evenly within the portfolio, with none making up more than 2.4%. The fund's 1.2% expense ratio is average for a small-cap no-load fund.

Performance data as of Aug. 20.

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