The Best Small-Company Funds

Investors gravitate to small companies for many reasons. Some want to participate in what has been called the "small-cap effect," or the theory that smaller companies have greater growth opportunities than larger companies and, as a result, have greater total return potential over time.

Others want a small dose of small companies in their portfolios to round out their exposure to the overall stock market. Still others like to tilt their portfolios toward small caps after a period of large-cap outperformance, such as we've seen during the trailing 12 months. No matter the motivation, investors seeking small-company exposure can begin their search with our shortlist of the best small-cap funds, or those funds that earn a Morningstar Fund Analyst Rating of Gold.

Passive Choices Half of our Gold-rated funds follow passive approaches. All of these passive strategies offer low-cost diversified exposure to small caps--but that's where the similarities end.

The most "traditional" index fund of the group,

Vanguard Tax-Managed Small Cap VTMSX, meanwhile, isn't technically an index fund, but it qualifies as a passive investment. Manager Michael Buek closely matches the fund's holdings to the S&P SmallCap 600 Index, which carries a quality bias. But Buek can take some liberties with sales in the name of tax efficiency. "He can extend his holding periods in order to qualify for long-term capital gains treatment," notes Rawson. So, although it looks like a straightforward index fund on the surface, Vanguard Tax-Managed Small Cap can deviate from the index during periods of redemption, when Buek would be focusing on limiting the tax impact of sales.

Four variations on DFA's passive philosophy round out the list. Rooted in empirical research, DFA's strategies all involve using passive screens to identify stocks with characteristics that have historically been associated with higher expected returns. As such, none of DFA's funds track an index.

The Open Actively Managed Option

Of the six actively managed Gold-rated funds, only one--

Diamond Hill practices a bottom-up, low-turnover, fundamental approach, focusing on stocks trading below their intrinsic values. "Over his almost seven years leading the fund, manager Tom Schindler has garnered one of the top records among his small-value peers by finding the stock-by-stock discrepancies in business value versus stock price," notes analyst Janet Yang. Schindler maintains a somewhat concentrated portfolio by small-cap standards (40 to 70 stocks, in general) and will allow cash to build if opportunities are scarce. Although this load fund is currently open, Diamond Hill has closed funds in the past to preserve their strategies.

How to Implement Given the lack of no-load options available today among our Gold-rated funds, investors seeking small-cap exposure may be wondering what to do. There are a few paths to take.

Consider one of the passive strategies. Passive strategies have several things going for them. First, of course, is their cost advantage: All of our Gold-rated passive funds carry below-average expense ratios, which give them a lower hurdle to jump over to generate returns. Moreover, passive strategies tend to be more tax-efficient than active strategies, which is a benefit for investors in taxable accounts. Finally, passive strategies are less threatened by asset growth than active strategies. As of this writing, all of the Gold-rated passive funds listed here land in the top half of their respective categories for the trailing 10-year period; four land in the top third.

Those investors seeking active management in the small-cap arena have choices, too. They can temporarily get exposure to the small-cap market via one of the passive strategies and put the currently closed Gold-rated active funds on their watchlist. One or more of these currently closed funds will probably reopen at some point: Several of the closed funds carry smaller asset bases today than when they closed a few years ago.

As another option, investors can delve into Silver- and Bronze-rated small-cap funds. Of the 19 small-cap funds earning Analyst Ratings of Silver, seven are active and open to new investors. And 14 of the Bronze-rated small-cap funds are actively managed and open to new investors. Premium Members can access a full list of all small-cap medalists

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