Reopened Small-Stock Funds Could Be an Opportunity -- or a Sucker Trap

A couple of years ago, every week or two would bring the announcement that a small-cap fund was closing, sending investors scrambling to get in before the gates slammed shut. But last fall's bear market took a little of the exclusivity out of the small-stock club. With assets dwindling and shareholders headed for the same doors many had just rushed to get in, small funds are no longer playing hard-to-get.

Talk about victims of their own success. After three solid years of outperformance at the start of the decade, investors flocked to small-cap funds, their cachet rising with each closing -- or even just the threat of closing. The trouble is, fund companies barred the doors just in time for the market to collapse. Small-caps have struggled to mount a sustained advance since 1994. An aborted rally in 1997 lured some investors back in, but apparently not the folks with staying power. "Some hot money flowed in -- and then it flowed right back out again," says Scott Cooley, an analyst with fund tracker Morningstar. Assets in (OAKSX)Oakmark Small Cap fell from roughly $1.5 billion to $600 million in a just few months last year, he notes.

Preston Athey, manager of the (PRSVX)T. Rowe Price Small-Cap Value fund, says he was getting redemptions for six months when he reopened the fund in November. "For two weeks I had money coming in; then I started seeing redemptions again." Fidelity, meanwhile, says assets in its (FLPSX)Low-Priced Stock fund fell from $12.1 billion last April when it closed to $7.8 billion at the end of February.

Now, not surprisingly, the doors have been flung open again at these and a host of other funds, almost all of them small-cap and many of them value funds.

Fund Reopened YTD return Assets (millions) (NASCX)Navellier Aggressive Small Cap 6/30/98 -6.5% $36.5 (OAKSX)Oakmark Small Cap 9/1/98 -7.8% $533.5 (MNMCX)Montgomery U.S. Emerging Growth 9/4/98 -13.6% $344.6 (TAVFX)Third Avenue Value 10/15/98 -6.2% $1,620 (PRSVX)T. Rowe Price Small-Cap Value 11/5/98 -8.5% $1,388 (SCMCX)Scudder Micro Cap 11/6/98 -3.2% $93.4 (HRTVX)Heartland Value 11/9/98 -6.2% $1,264 (FLPSX)Fidelity Low-Priced Stock 3/17/99 -6.4% $7,837 (FSLCX)Fidelity Small-Cap Stock 3/17/99 -4.2% $489.7

Source: Morningstar

Does the reopening of these funds represent a limited-time offer for choice merchandise at sale prices? Or is it just another come-on for suckers who'll wind up getting clobbered? At the risk of talking out of both sides of my mouth, I'll say both characterizations are true. It's all a matter of timing.

Anyone who bought into these funds recently looking for a quick buck is already disappointed -- just look at their "returns" next to the S&P 500's 5.5% gain so far this year. And even fans say the outlook for small stocks is problematic. Small stocks do best at the beginning of economic cycles, not near the end. Analyst Claudia Mott at Prudential Securities just doesn't see the earnings momentum that small stocks need to take off.

But others look at small-stock valuations and say investors who buy now will be rewarded -- maybe later instead of sooner, but rewarded nonetheless. Small stocks, after all, are cheaper than they've ever been relative to blue-chips. And they're selling at levels comparable to those they sold at in the spring of '77 and the fall of '90 -- periods that ushered in five-year winning stretches.

Meanwhile, how can any but the most shortsighted investor quibble with the long-term records of some of these funds? Joel Tillinghast of Fidelity Low-Priced Stock has returned 17.8% a year to investors since the fund's inception nearly 10 years ago. Oakmark's Small Cap's Steven Reid has netted investors 15.4% a year since the fund's debut in 1995. And Marty Whitman's (TAVFX)Third Avenue Value has delivered 18.5% a year for nearly nine years. The word that comes to mind for the reopening of these funds is "opportunity."

Which is exactly what the so-called "smart money" sees plenty of in small stocks, even if retail investors don't. Consider two telling developments:

Last year, while retail investors were pulling money out of small-cap value funds, institutional investors were putting money in, according to cash flow estimates from Morningstar. Among the biggest gaining institutional funds:

Fund 1998 Net Cash Flow Gain DFA U.S. 6-10 Value $464 million 21% BlackRock Small Cap Value Inst. $317 million 63% Pimco Small Cap Value Inst $198 million 84% Berger Small Cap Value Inst. $168 million 124%

Source: Morningstar

Meanwhile, four newly reopened retail funds made the top-10 list of asset losers:

Fund 1998 Net Cash Flow Loss Fidelity Low-Priced Stock -$1.5 billion 14% Heartland Value -$357 million 17% T. Rowe Price Small-Cap Value -$204 million 10% Third Avenue Value -$121 million 7%

Source: Morningstar

Bigger companies are acquiring small ones at an unprecedented rate, at least in Athey's Small Cap Value fund. A record 16 of his companies were taken over last year, says Athey, and at hefty premiums to boot. This year is on track for another record, with four takeovers already announced. "Corporate America is arbitraging the opportunity that the stock market has given it," says Athey.

What does the "smart money" see that you and I don't? Nothing. We're all looking at a market dominated by big-cap blue-chips and fast-growing tech stocks with nothing to suggest a change in leadership anytime soon. But the pros have the foresight, the discipline -- or maybe just the patience -- to be early. I'm not advocating a full-scale portfolio shift in favor of small stocks. (Hey, I'm not crazy.) But a little diversification by way of some dollar-cost averaging seems in order. And now seems like a good time. "By the time you've seen the turn," says Athey, "you won't be able to get in."

Oh, and by the way, (SCMCX)Scudder Micro Cap, for one, says it's closing again when assets reach $150 million.

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