A High-Quality, High-Conviction Small-Cap Fund

The following is our latest Fund Analyst Report for Virtus Small-Cap Sustainable Growth Fund PXSGX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

A disciplined management team has effectively used a quality-oriented investment process to produce superior results here, earning Virtus Small-Cap Sustainable Growth (which will be renamed Virtus KAR Small-Cap Growth in May 2017) a Morningstar Analyst Rating of Bronze.

Comanagers Todd Beiley and Jon Christensen have run the fund since 2008 and 2009, respectively, and have been on the investment team at subadvisor (and wholly owned Virtus subsidiary) Kayne Anderson Rudnick since the early 2000s. They also manage Bronze-rated

The fund uses a high-conviction approach to get the most out of its stock picks. With an average position size of 3%, the roughly 30-stock fund tends to keep around half of its assets in its top 10 positions, and those don’t change too often. Indeed, the fund’s turnover has averaged near 30% over the past five years, much lower than the small-growth Morningstar Category average of 84%. The long-term focus, emphasis on high-quality companies, and strong stock-picking have delivered the best of both worlds. The fund has beaten peers and the Russell 2000 Growth Index since Beiley joined in early 2008, largely by adding alpha in down markets, but it has also participated in market rallies. The fund landed in the category’s top 3% or better over the trailing three-, five-, and seven-year periods ending March 2017. The fund also maintains an edge when accounting for risk, with superior Sharpe and Sortino ratios and Morningstar risk-adjusted returns.

The fund’s one drawback are its expenses, which are above average to high (depending on the share class) relative to other small-cap peers.

Process Pillar: Positive | Christopher Franz 04/11/2017

Comanagers Todd Beiley and Jon Christensen ply a sensible investment process at this fund that is centered around two main pillars: high quality and high conviction. Their definition of high quality is multifaceted, but evaluates companies on factors such as their competitive differentiation, cash flow generation, and efficacy of their management teams. Conviction is key, as the fund owns between 25 and 35 stocks, often for the long term. The fund earns a Positive Process Pillar rating. Further defining high quality, the group seeks out small-cap stocks that exhibit strong brand franchises, clear cost advantages, and high customer-switching costs. They look for companies with low leverage and capital intensity and a high degree of self-financing, exhibited by strong free cash flow. These measures help point the team to businesses that can compound their growth at strong annual rates for up to 10 years. The managers are focused on owning businesses with long-term, sustainable, organic growth prospects. Besides closely evaluating new stock ideas, Beiley and Christensen, who make portfolio decisions together, are highly focused on portfolio risk. They've implemented a strict sell discipline and review process should a stock's price decline more than 20%. The high-conviction approach of comanagers Todd Beiley and Jon Christensen is displayed in the fund. The portfolio held 26 stocks as of year-end 2016, with an average position size near 3.5% and nearly half of the fund's assets invested in the top 10 holdings. Positions can be up to 10% of fund assets, but the largest holding as of December 2016, digital imagery company Shutterstock SSTK, was about 6% of assets. The fund is also allowed to deviate up to 10 percentage points from its Russell 2000 Growth benchmark's weightings. It's historically been heavy in industrial and consumer staples stocks, while being underweight material and healthcare stocks. True to their long-term orientation, Beiley and Christensen don't trade too often. For the five-year period ended December 2016, the fund's average annual turnover was just under 30%, much lower than the small-growth peer group's average of nearly 84% per year. The managers only added four new stocks in 2016. The fund also owns smaller companies than most peers, with a weighted average market cap that is nearly half the category average. The fund lands in the small-growth category, but isn't overly aggressive and does share some similarities with its cousin, Virtus Small-Cap Core, managed by the same team. As of December 2016, 11 stocks were owned in both funds; generally one third of their holdings overlap.

Performance Pillar: Positive | Christopher Franz 04/11/2017

Todd Beiley and Jon Christensen have delivered a strong and consistent risk/reward performance pattern over their tenure, earning the fund a Positive Performance Pillar rating. Since Beiley came aboard in April 2008, the fund's 12.4% annualized return has soundly beaten the Russell 2000 Growth's 10.1% and average small-growth peer's 8.6%. The fund has landed in the category's top 3% or better over the trailing three-, five-, and seven-year periods ending March 2017. Beiley and Christensen haven't taken excessive risk to achieve these results, either. The fund's risk-adjusted returns over the same time periods are superior to its benchmark and peers, as are its Sharpe and Sortino ratios. The team has posted outsize returns in strong markets, such as 2016, which was largely due to strong stock selection, particularly within cyclical names. But the fund has shown it can protect capital in down markets. In the two calendar years that both the benchmark and peers have posted negative returns since Beiley and Christensen assumed control of the fund, the fund posted positive absolute returns. That isn't to say that the fund won't underperform, as it did in 2010 & 2014's strong market rallies, but the managers' focus on quality companies and downside protection has thus far been a benefit to investors.

People Pillar: Positive | Christopher Franz 04/11/2017

Managed by a duo at subadvisor Kayne Anderson Rudnick, a wholly owned subsidiary of Virtus Investment Partners, this fund benefits from its managers' experience and patient, long-term approach. The fund earns a Positive People Pillar rating. Todd Beiley and Jon Christensen lead the fund, and have been listed managers since 2008 and 2009, respectively. Beiley joined subadvisor KAR in 2002 as a sector analyst supporting small- and mid-cap portfolios, as did Christensen in 2001. Both managers had analytical experience prior to joining, with Beiley having spent time at Prudential and Christensen at PIMCO, but the vast majority of their investment careers have been spent with KAR. Despite their management duties, the two still retain sector coverage, with Beiley covering financials and consumer stocks, and Christensen covering healthcare. Supporting the duo are five additional analysts, three of whom are dedicated to small- and mid-cap stocks. Beiley and Christensen are listed managers on other small- and mid-cap strategies, including Bronze-rated Virtus Small-Cap Core, a core-offering managed in the same style as this fund. Their indicated ownership levels are low, between $1-$10,000 each. However, they state they are heavily invested through other vehicles.

Parent Pillar: Negative | 03/31/2017

Virtus Investment Partners VRTS operates an affiliated partners approach to its investment lineup. In 2014 and 2015, it exhibited poor stewardship when it did not explain to fundholders why it was sticking with subadvisor F-Squared through a regulatory inquiry and for five months after F-Squared admitted wrongdoing in an SEC settlement. In November 2015, Virtus reached its own settlement with the SEC, which concluded Virtus inadequately supported its marketing of F-Squared's falsified performance record. The experience with F-Squared suggests Virtus' subadvisor due diligence process was substandard, and other short-term relationships support that view. Currently, Virtus wholly owns four subsidiaries, while the firm has hired several others as subadvisors. That list of partners, however, has changed over the years, as the firm has launched, merged, and liquidated mutual funds along the way. For example, the firm engaged investment consultant Cliffwater LLC in a joint venture to run several multimanager funds, only to liquidate them after two years. Virtus does have some solid affiliates, including wholly owned Kayne Anderson Rudnick and subadvisors Vontobel and DFA. The firm is acquiring Ridgeworth, which we rate Neutral. Overall, though, concerns about compliance and churn among affiliated managers and accompanying strategies, along with generally higher-priced offerings, keep Virtus' rating at Negative.

Price Pillar: Negative | Christopher Franz 04/11/2017

The fund's fees are high compared with comparable small-cap peers, warranting a Negative Price Pillar rating for the fund. The fund's Institutional share class holds around two thirds of the assets and charges 1.25%, compared with 1.00% for its average institutional peer. The fund has received sizable inflows in recent years as it has posted strong relative and absolute returns, growing over fourfold from its year-end 2015 asset level. The team is being considerate of capacity, which they estimate to be near $4 billion. As of March 2017, total strategy assets, also including separate accounts managed in this fund's style, totaled just under $1 billion.