Dear Dagen: Hunting the Undiscovered Small-Cap

How do I find a good small-cap fund?
--Charles Roberts

Small-cap funds are a lot like neighborhood restaurants. Once they're discovered, they become too crowded and lose their appeal.

Finding a fund that hasn't been overrun by investors is just one of the challenges when picking a small-cap fund. Of course, there are the usual considerations: expenses, manager experience and diversification. But here are some suggestions to keep in mind when you're hunting for a small-cap investment, and some funds to consider.

Size Kills

First and foremost, you want to find a small-cap fund that hasn't grown too big. In the world of small-cap investing, size can be a performance killer.

Smaller companies offer a limited number of shares to the trading public. A manager of a small-cap fund that has taken in too much money can't put enough cash in any one stock to make a big difference in the fund's performance. And buying too many shares in any one illiquid stock can create wild swings in that stock's price that could actually hurt the fund's performance.

As a fund grows larger, the manager could be forced to buy not only more stocks, but also stocks of larger companies. Before you know it, a hot small-cap fund riding 50 stocks can turn into a sluggish mid-cap fund sitting on 200. The Kaufmann fund -- now the Federated Kaufmann fund -- is a classic example. By the mid-'90s, its assets ballooned to more than $6 billion, and the fund morphed from a soaring small-cap fund invested in about 75 stocks to a lumbering mid-cap with about 450 holdings.

And those bulging assets hurt performance. The fund landed in the bottom 20% of its category in 1998 and 1999. Today, Kaufmann is producing solid returns with more than $3.5 billion in assets -- and closer to 250 holdings -- but its days as a scorching small-cap fund are long gone.

That raises another important question: How big is too big? Unfortunately, a specific rule doesn't exist. Some funds close at $500 million, while others do well with more than $1 billion under management.

In general, a fund that invests in micro-cap stocks and has high turnover -- of, say, more than 100% -- must stay smaller than one that buys stocks of slightly larger companies and doesn't trade as often. And because value fund managers tend to trade less than growth managers, a small-cap value fund might be able to handle more money.

One basic rule to follow: You don't want the fund's assets to be higher than its median market cap. (You can find both of these statistics on Morningstar's Web site.)

Commitment to Closing

Moreover, you want to find a fund that has promised to close when its assets reach a certain level, or shown a willingness to close in the past. The giant $13.5 billion (FLPSX Quote)Fidelity Low-Priced Stock fund has closed three times in the past and will surely close again if the inflow of money is too much for manager Joel Tillinghast to handle. (Despite its size, this fund continues to produce outstanding returns, proving that there are exceptions to every rule.)

And the managers at Wasatch have been diligent about closing their successful funds. Of the six stock funds in the Wasatch family, only two are open to new investors. The managers of the superb (BUFSX Quote)Buffalo Small Cap fund have said they would consider closing the fund when its assets hit $1 billion. And thanks to its 31.2% return last year, the fund has already passed that mark. For now, Buffalo Small Cap is still open to new investors, but you must buy shares of it directly from the fund company.

That raises another problem: You want a fund that's willing to close before it gets too big and changes character. But when it does, you're probably locked out unless the performance heads south and it's forced to reopen.

Last year, small-cap value funds were the place to invest. The average fund in that category was up 17.2% in 2001. And that impressive performance in an otherwise dismal year has attracted a lot of new money.

Frankly, it's hard to find a good small-cap fund that's still open to new investors. The (ARTVX Quote)Artisan Small Cap Value fund is closed. So is the Turner Small Cap Value.

In fact, the best time to look for a small-cap fund is after the group has performed poorly for a year or two. Rather than looking at value right now, you should take a look at funds that are more growth-oriented. Small-cap growth funds didn't have such a good year in 2001, falling 9%. As a result, you can find some exceptional ones that are still open. (Plus, small growth stocks tend to outperform coming out of a recession.)

Morningstar's fund research director Russ Kinnel offered the following two suggestions.

John Bogle Jr.'s eponymous Bogle Small Cap Growth fund is worth a look. Bogle built an impressive record running the N/I Numeric Micro Cap fund using a similar quantitative strategy. And in this tricky part of the market, experience isn't just a plus. It's a must.

Bogle opened this fund in September 1999 and its one-year return of 0.7% ranks in the top 8% of all small-growth funds. And he has promised to close this $131 million fund when assets hit $150 million - which could happen any day now.

The (WPSRX Quote)Westport Small Cap fund is another fund backed by two seasoned managers. Andy Knuth and Ed Nicklin have decades of experience between them. The fund's expense ratio is also below average for a small-cap fund.

Its three-year annualized return of 20.5% beats 90% of other small-cap blend funds. The fund is down 2.2% for the past year. But that lackluster return has kept the hot money out and this attractive fund open.

If you have a favorite small-cap fund that's cheap, well-run and still open, tell me about it.