Small-Cap Index Beaters

For investors following a core-and-explore approach--that is, using index funds as the base of a portfolio and actively managed funds for complementary holdings--small-cap funds are often regarded as an area in which active management can add value over passive management. The conventional wisdom is that small-cap stocks are usually less well-known and less widely held than their large-cap counterparts, making them an area ripe for talented active fund managers to use their stock-picking skills, not to mention putting together portfolios that look less indexlike.

This week our Index Beaters series looked for actively managed small-cap stock funds that have outperformed during medium (five-year) and longer (10-year) terms. As we've done in previous installments, we'll use an index proxy as our benchmark, this time in the form of the  Vanguard Small Cap Index (NAESX) fund, a low-cost offering that tracks the MSCI U.S. Small Cap 1750 Index (prior to May 2003 it tracked the Russell 2000 Index).

Once again we used Morningstar's  Premium Fund Screener tool to search for all small-cap funds (growth, value, and blend) that beat our index proxy during five- and 10-year periods. Out of the 317 actively managed small-cap funds with 10-year track records in our database (including institutional funds and those currently closed to new investors) one fourth beat the index proxy during the past five years while slightly less (22%) did so during the full 10-year time frame. However, when we screened on funds that outperformed the index proxy during both time frames, the number fell to just 11%, illustrating how difficult it can be to outperform the index consistently. (Also note that we didn't account for funds that existed at some point during the past decade but closed or merged away, so the actual percentage of actively managed funds outperforming the index could be even lower).

Our next step was to identify quality funds among this smaller group of long- and mid-term index beaters that might be of interest to new retail investors. We screened out institutional funds and those closed to new investors, and searched for those with Morningstar Analyst Ratings of Bronze or better. Out of the 11% mentioned above, only a handful of funds made the cut. Three of them appear below, and Premium Members can see the full screen  here.

 Brown Capital Management Small Company Growth (BCSIX)      
5-Year Annualized Return: 6.2% | 10-Year Annualized Return: 11.5%     
In a notoriously volatile category, this fund's veteran management team focuses on quality companies with strong balance sheets, durable revenue streams, and defensible market positions. Their buy-and-hold philosophy results in a low 21% annual turnover. The benchmark-agnostic portfolio is dominated by technology (65% of holdings as of Sept. 30) and health-care (19%) names while largely avoiding consumer cyclical, industrials, and financial-services stocks. The fund tends to outperform in down markets--for example losing 30.1% in 2008, when small growth funds lost 41.5% on average. Five- and 10-year annualized performances are both in the top 3rd percentile of the category. 

 Fidelity Small Cap Discovery (FSCRX)              
5-Year Annualized Return: 9.9% | 10-Year Annualized Return: 11.4%     
This small-blend fund's impressive recent track record (top 5th percentile in the category for the trailing one-, three-, and five-year periods) is largely attributable to the stock-picking skills of manager Chuck Myers, who took over in 2006, says Morningstar fund analyst Katie Rushkewicz Reichart. Myers keeps sector weightings close to the fund's Russell 2000 benchmark but takes a value-oriented approach that has served investors well, particularly in financials, which represented 20% of the portfolio as of July 31. The fund's five-year annualized returns are a whopping 9 points better than the small-blend category average. Fees are below-average for the small-cap no-load group. 

 T. Rowe Price Small-Cap Value (PRSVX)       
5-Year Annualized Return: 3.6% | 10-Year Annualized Return: 11.2%     
This fund comes with a caveat. Manager Preston Athey, at the helm since 1991, will step down in mid-2014 and will be replaced by David Wagner, associate fund manager since 2005. Wagner has said he plans to maintain the fund's diversified, low-turnover strategy, buying stocks based on absolute and relative valuations. Another issue to watch is the fund's $7.5 billion asset base, among the biggest for an actively managed small-cap fund and a potential liability for a fund investing in small-company stocks. Those issues aside, this fund has achieved top 10th percentile performance in the trailing five- and 10-year periods while keeping volatility below that of its peers. Rushkewicz Reichart calls the fund "a good fit for risk-conscious investors who want exposure to small-cap stocks without as much volatility." The fund charges 0.82% in expenses, low for the small-cap no-load group.

Performance data as of Oct. 26.