Doors Slamming Shut on Investors Chasing Hot Small-Cap Growth Funds

As the sector sizzles, cash pours in. But too much cash can choke a small-cap fund.
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In the paradoxical world of small-cap funds, the better they're doing, the less chance you have of getting in on the action.

Small-cap growth funds are having a banner year, thanks to a market fueled by technology stocks and hot initial public offerings. These funds are returning an average of 46.6%, according to

Lipper

, and at least two dozen small-cap funds are members of

TheStreet.com's

Century Club, the 96 domestic stock funds returning more than 100% for the year.

But at the same time, many small-cap funds are closing their doors to new investors. Of 34 closed small-cap funds, 10 have shut their doors this year, according to Chicago fund-tracker

Morningstar

.

Thursday, yet another small-cap fund, the $251 million

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Pilgrim SmallCap Opportunities, announced it would close to new investors on Feb. 29, 2000.

The reason: High returns lure new cash from investors, which can leave a small-cap fund swamped. A small-cap fund with too much cash is often less nimble, causing performance to drag.

The rash of closings is particularly ironic, given that billions of dollars have fled the small-cap sector this year. Investors have withdrawn $10.6 billion more than they've invested in the Lipper small-cap category, according to Boston fund researcher

Financial Research

. Excluding lagging small-cap value funds from the picture and focusing only on Morningstar's small-cap growth category, outflows still amount to $1.2 billion.

It shows that the money going into the sector is focused on a relatively small number of high-performing small-cap funds. And that can be problematic for those funds.

Once a small-cap fund grows beyond $1 billion to $1.5 billion in assets, many fund firms have a tough choice: Close the fund, or change its style by taking inordinately large positions in small stocks, holding hundreds of stocks or investing in mid-cap stocks.

"It doesn't surprise me that a lot of these funds are closing. Some portfolio managers are probably saying they can't manage that much money. You have to keep current shareholders in mind," says Jim Folwell, a consultant with Boston fund researcher

Cerulli Associates

.

In the past, many small-cap funds seemed to have a hard time turning away investors' cash. But this year is different. Many funds are closing well below the $1 billion bogey. The early closures indicate some companies learned painful lessons from 1995, the last time small-cap growth stocks took off. Back then many small-cap funds' assets bulged beyond the $1 billion mark, then promptly sagged as small-cap growth stocks slumped lower in each of the next three years.

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AIM Aggressive Growth is an example of a small-cap fund that grew too big, says Christine Benz, associate editor at Morningstar. The fund posted returns that beat two-thirds of its small-cap growth peers from 1992 to 1995 and assets grew into the billions.

The fund has closed and opened several times since1994, but it has only cracked its peer group's top half in one calendar year since 1995, according to Morningstar. The fund is currently open to new investment, and had assets of $3.3 billion on Nov. 30, about 10 times larger than its average small-cap growth peer.

But AIM closed two small-cap funds (

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Small Cap Opportunities and

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Small Cap Growth) when they had around $500 million in assets in November. AIM spokesman Ivy McLemore says the two smaller small-cap funds' strategies warranted early closure, but that assets haven't been a problem with Aggressive Growth. That's probably because the fund had nearly 40% of its assets invested in mid-cap stocks on Nov. 30, according to Morningstar.

Given the number of successful small-cap funds that have closed recently, it is tempting to make a minimum investment to gain a foothold in a promising fund before it closes.

But observers say there's no need for panic. "There are very few clearly superior products out there. I can't think of a small-cap manager who stands out, and there's plenty of product to choose from," says Cerulli's Folwell.

Also, rushing to get a foothold in a favorite fund might play into fund marketers' hands. Some closures are marketing ploys. Sometimes, companies announce a fund will close in a few weeks, manufacturing an air of urgency.

"Beware fund companies that give a 30-day period before closing a fund," says Morningstar's Benz.

Hambrecht & Quist

announced a 30-day closeout period on Dec. 1 for its

IPO and Emerging Company

fund. At that point the month-old fund had $330 million in assets. Today assets are around $450 million and could reach $500 million before it closes, according to H&Q's top marketing officer, Dave Krimm.

Krimm doesn't have a problem with giving investors 30-days notice.

"I'm sure it does create more urgency, but the alternative is to close it at a given asset level, which is more manipulative. We gave people 30 days to figure out if they want to invest. It gives people time to plan. If we closed it at X assets, you as an investor have to guess when that might happen," he says.

Despite the chorus of slamming doors, Benz thinks plenty of small-cap funds will still grow too big.

Century Club-member

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Robertson Stephens Emerging Growth could become an example. Popular manager Jim Callinan took the reins in July 1996 and has shot the lights out. Assets were just $193 million when he arrived, but have grown to $2.6 billion as of Nov. 30. He also runs more than $800 million in private accounts employing a similar style.

Although Callinan may have room to grow since he generally holds many stocks, Morningstar recently re-classified the fund as a mid-cap. Investors should keep their eye on the fund's asset level, because its tech-driven 157.2% year-to-date return should draw more money.