Small-Cap Funds That Stand Up to the Bear

Investing for the long haul sometimes requires wearing short-term blinders. A case in point: Investors who have ridden the current bull market's string of record highs, while happily watching their portfolios increase in value, may now be casting a wary eye toward what may come next. The sheer length of the current rally, which began in early 2009 and which currently ranks as the fifth longest since 1926, has caused some investors to assume that a correction is coming sooner rather than later.

Dramatically shifting your asset allocation out of stocks to avoid a downturn probably isn't a good idea, especially for assets you won't need to touch for five years or more. After all, timing the market is difficult to do and could cause you to miss out on additional gains if the bull keeps running. Although stocks aren't cheap, they don't appear to be outrageously overpriced, either.

Besides, your other investing options aren't exactly enticing. Investing in bonds means taking on interest-rate risk, and cash yields almost nothing. But for investors who worry that a correction in stocks is coming, or even a bear market--defined as a 20% decline from the market's recent peak--there are steps you can take short of reallocating into bonds or cash.

One is to check how an equity fund has fared in down markets by looking at its Bear Market Percentile Rank, which compares its performance with that of all equity funds in months during the trailing five-year period when the S&P 500 index lost at least 3%. This metric can be found under the Ratings & Risk tab on the Morningstar.com fund pages, in the Volatility Measures section (click on the 5-Year tab). One thing to keep in mind, however, is that the bear market of 2008 is no longer included in the calculation, so looking at how a fund performed that year also offers a clue as to how it might perform in another downturn.

Last week we looked at large-cap funds that have outperformed in bearish conditions. Given that small-cap funds have outperformed large-cap funds during the past half decade by an average of about 21% to 19% per year, it only makes sense to follow up by seeing which small-cap funds have fared better than others under bear-market conditions.

To that end we performed a similar screen to that of last week using the  Premium Fund Screener tool. However, unlike our large-cap fund exercise, our search for small-cap funds that have performed better than other equity funds in market downturns was hampered by the fact that many quality small-cap funds are now closed to new investors following strong performances that have swollen their asset bases. Closing a small-cap fund once its asset base becomes too big is generally seen as a sign of good stewardship because if the fund weren't closed, it could be difficult for the managers to effectively execute the fund's investment strategy. 

A screen on small-cap funds with bear-market ranks above (better than) the 50th percentile produces 47 results (not including institutional funds). But of that number about one third are closed to new investors. Among medalist funds--those rated Bronze or better by Morningstar analysts--the pickings are even slimmer. Out of 15 medalist small-cap funds that qualify, just four are currently open to new investors. Finally, because Bear Market Percentile Rank looks only at the past five years of data, we've added an additional screen to weed out funds that performed worse than their category averages in 2008, the last time the bear roared for an extended period. This whittles down our list still further, to 18 funds and three medalists.

For investors interested in small-cap funds that may fare better than their peers should the market head south, the list found  here can serve as a starting point. It includes the following funds.

 Conestoga Small Cap (CCASX)   
     
This fund's managers take a relatively conservative approach to the small-growth universe, says Morningstar senior fund analyst Janet Yang. They like companies with strong franchises, requiring at least a 15% return on equity from the fund's holdings. On top of those quality requirements, the managers' analysis has to show that each investment has the potential to appreciate by at least 100% during the next three- to five-year period. The portfolio of 40-50 stocks is generally well-diversified but does have a notable overweighting to tech stocks, which make up about 40% of the portfolio compared with 24% for the average small-growth peer. During its history, the fund has outpaced its typical peer two thirds of the time when markets were falling, Yang says. In 2008, for example, the fund lost 27.4%, but that decline was less severe than 98% loss its category peers suffered. The fund is coming off a strong 2013 in which it returned 49.3%, but it has lagged badly in 2014, losing 10.7% as of July 11, making it one of the category's worst performers during that time. The fund's expense ratio of 1.10% is below-average for a small-cap, no-load fund, though a fee waiver is set to expire in January 2016.

 Royce Total Return (RYTFX)    
     
Morningstar senior fund analyst Karin Anderson says this small-blend offering is best-suited for investors looking for a smoother ride in a fund that focuses on small companies. Its managers look for dividend-paying micro- and small-cap stocks with the best combinations of balance sheet quality, high returns on invested capital, and earnings stability. Their cautious approach, which includes an emphasis on buying stocks trading at healthy discounts to intrinsic value, has delivered during down markets. The fund's 31.2% loss in 2008 was about 5 percentage points better than that of the average small-value fund (its category at the time). However, in rising markets, it typically struggles to keep pace. Its 32.4% gain last year lagged the small-blend category by 5 percentage points. The fund carries a Morningstar Risk rating of Low, but its conservative approach doesn't come cheap. Annual expenses are 1.48%, high for a small-cap, no-load fund.

Ratings as of July 15. 

Editor's note: This article has been changed to reflect the fact that the Bear Market Percentage Rank metric is calculated based on a fund's performance relative to all equity funds, not just those in the same fund category.