A Wild Ride, but Some Might Find These Small-Cap Funds Worth It

For most investors, volatility is an unwelcome attribute in a fund. Today's rocky market presents more than enough uncertainty for their appetites. Last week Five-Star Investor looked at funds with below-average Morningstar Risk ratings in a notably volatile segment of the market: small-cap stocks. The idea was to identify funds our analysts like and that also provide exposure to small-company stocks without the bumpy ride that is often part of the bargain. After all, lower volatility helps reduce the chances of investors reacting to dramatic market swings by jumping into and out of funds, which tends to be a recipe for poor investor performance.

But for investors who don't mind a bit of drama in their portfolios, we turn this week to higher-risk small-cap funds that our analysts think have a good shot of delivering high long-term returns to compensate for all that volatility. Above-average risk might indicate that a fund's management team is more willing to take chances than its competition by, say, delving into micro-cap or high-priced stocks or building concentrated portfolios. To be sure, these funds are not for everyone, and the conventional wisdom about keeping volatility at bay still applies. But for those with a sufficiently long holding period who are undeterred by the roller-coaster ride these funds provide, we offer the following screen.

Using Morningstar's Premium Fund Screener, we searched for small-cap funds with Morningstar Analyst Ratings of Bronze or better and Morningstar risk ratings of above average or high. Recall that the Morningstar risk rating measures volatility relative to a fund's peer group, with an emphasis on volatility to the downside. We stuck with no-load, noninstitutional funds with initial investments of $10,000 or less, and included the Distinct Portfolio screen to eliminate multiple share classes of the same fund (Note that Distinct Portfolio generally shows only the oldest share class of each fund; to see all share classes, including those of funds that might not appear on the initial screen, simply remove Distinct Portfolio.) Premium users can click here to see the full screen, which includes the following funds.

Janus Venture D (JANVX)
This fund made it through our screen because its risk scores were high in the past, pushing up its overall risk rating (Morningstar's risk score encompasses risk over the past three-, five-, and 10-year periods). But that could be changing under its relatively new management team as its three-year risk rating was below average. Managers Chad Meade and Brian Schaub, who took over in 2010, focus on quality firms with sustainable competitive advantages. On their watch the fund has tended to outperform its peers in down markets while performing slightly better-than-average in up markets. The fund's one- and three-year annualized returns both beat the category average by more than 4 percentage points. (Note: The screen shows the fund's D shares, but availability is limited to current Janus investors and their families. Other share classes are open to new investors.)

Bridgeway Ultra-Small Company Market (BRSIX)
Investors wishing to own some of the market's smallest stocks might find this an intriguing option. The fund seeks to approximate the return of the CRSP 10 Index, which is made up of the smallest 10% of companies (by market cap) on the New York Stock Exchange. The fund's portfolio holds more than 600 stocks, with an average market cap of just $182 million, or about one tenth that of the average small-blend fund. To help limit volatility, the fund uses a screen that helps weed out companies in the index that are at risk of going bankrupt. The fund's 10-year annualized return of 9.5% puts it in the top quintile of the category. Although performance has been lackluster in recent years, the fund's 13.8% return so far this year puts it in the top 10th percentile for the category. Fees here are low for the category at 0.75%.

Royce Opportunity (RYPNX)
The lone fund on our screen with a risk rating of high has earned its daredevil reputation. Manager Buzz Zaino, at the helm since 1998, is willing to bet on companies with shaky financials, and he further courts chaos through sector bets, with current overweightings in tech and consumer cyclicals. He likes stocks he sees as undervalued asset plays, turnaround stories, special situations (such as firms emerging from bankruptcy), and busted IPOs. The fund's zig-zag performance pattern was on display during the financial crisis, when its 2008 loss of 46 points lagged the category by more than 13 points only to be followed in 2009 by a 62-point gain, about 31 points better than the category average. The fund has delivered top-decile annualized performances in the trailing 10- and 15-year periods, with above-category-average one- and three-year performances. Morningstar analyst Karin Anderson says Zaino's "knack for picking up underfollowed firms, plus his valuation discipline, has made this fund a standout among micro-cap funds and the broader small-value group."

Performance data as of Aug. 27; portfolio data as of June 30.