Seeking Out a Winning Small-Cap Fund

Like surprisingly tough speedboats, small-cap stocks have weathered the past year's storm better than those tankers with Cisco(CSCO Quote) or Lucent(LU Quote) painted on their sides. If you're shopping for a seaworthy small-cap growth fund, we've done some fishing for you.

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After casting our nets into the ocean of more than 240 small-cap growth funds out there, we suggest you consider the no-load (MGSEX Quote)Managers Special Equity fund, the latest entrant into our Ima Winner Fund Club. On the flip side, we suggest you steer clear of the broker-sold (QUASX Quote)Alliance Quasar fund, which has sputtered so consistently it might become president of our Ima Loser Fund Club.

It's understandable if you're not enthused about this category after the dreary past 18 months. Even the Managers fund we've highlighted is under water this year, though its 7.5% loss is better than its average peer or the S&P 500, both of which are down more than 11%. It hasn't been a pretty stretch, but a diversified portfolio should have between 5% and 10% of its money in this style, and these funds can heat up in a hurry. The average small-cap growth fund rang up a 58% gain in 1999; its 16.2% annualized gain over the past three years more than triples the S&P 500's.

The Stud

The hallmarks of a good fund are above-average returns paired with below-average volatility and expenses. That's what you'll find if you check out the Managers Special Equity fund, which I've owned for about three years.

Past Winners

Large-Cap Value: Dodge & Cox Stock

Large-Cap Growth: Growth Fund of America

Mid-Cap Growth: Bridgeway Aggressive Growth

Tech: Dresdner RCM Global Technology

Health Care: Vanguard Health Care

The fund is co-managed by five firms, each focusing on small- and micro-cap stocks with a different approach. That might sound like too many chefs, but the fund has beaten its average peer over the past one, three, five and 10 years. Its 16.4% annualized gain over the past 10 years beats 88% of its peers and leads the S&P 500 by 2%. The fund has topped its average competitor in seven of the past 10 years, according to Chicago fund tracker Morningstar.

The key to the fund's success is that it spreads its $2.3 billion asset base among managers with different approaches, including growth specialists like Gary Pilgram from PBHG and value types like Bill Dutton, who runs the (SKSEX Quote)Skyline Special Equities fund. Unlike funds that rise and fall with one style, this fund offers solid all-weather returns. Owning five different managers' picks has led to a sprawling 350-stock portfolio. That doesn't seem to have held the fund back, however, and it has fallen less than its average peer in down months over the past three years.

Finally, the fund's shareholders haven't lost a lot of their gains to taxes or expenses. The fund has been more tax-efficient than 88% of its peers over 10 years, according to Morningstar. And its price tag isn't too steep: The no-load fund's 1.26% annual expense ratio is well below the category's 1.62% average.

Hi, Ima Winner

Source: Morningstar. Returns through Aug. 26.

The Dud

Let's have a moment of silence for those poor souls who own the Alliance Quasar fund.

Past Losers

Large-Cap Value: Seligman Common Stock

Large-Cap Growth: Putnam New Opportunities

Mid-Cap Growth: Putnam OTC & Emerging Growth

Tech: T. Rowe Price Science & Technology

Health: Invesco Health Sciences

The fund lags behind both its average peer and the S&P 500 over the past one, three, five and 10 years. The fund has trailed its average peer in each of the past four years; its measly 2.4% annualized gain over the past five years trails 85% of its peers. Its 9.4% annualized return over the past 10 years does the same.

Over the past three years shareholders have averaged an annual loss of 2.5%. Even worse, the fund has been less tax-efficient than 80% of its peers over 10 years. Translation: Yes, you've lost money, but you've been stuck with higher tax bills, too, thanks to some taxable distributions.

Some hardcore optimists might say there's hope for the fund. Bruce Aronow, who became the fund's sixth manager in 10 years when he took over at the start of 2000, has applied a stricter focus on companies with solid earnings growth.

His style may pay off eventually, but the fund narrowly lagged behind its peers last year and is doing the same in 2001. It's hard to know what to expect from Aronow because this is his first stint running a retail mutual fund.

Hey, Ima Loser

Source: Morningstar. Returns through Aug. 26.

To top it all off, the broker-sold fund's 1.67% annual expense ratio is higher than the category average. Guess you don't always get what you pay for.