If you're looking for a mutual fund to trounce the lackluster market this year, you might want to look beyond the hulking, muscle-bound giants to a spry smaller fund. The key: knowing the difference between a nimble bantamweight and your average 98-lb. weakling.
Schroder Micro Cap, one of the year's top performers with a 115.2% return. It has only $77 million in assets -- up from $24 million a year ago.
American Eagle Capital Appreciation, with only $14 million in assets, is up 93.2%.
On average, smaller funds aren't posting stellar returns, but several offerings with minuscule asset bases -- including those focused on the health care and biotech sectors -- have been among this year's top performers. While it's not a cakewalk to pick the winners, investors looking for revved up market returns may want to look for smaller funds with the right ingredients -- such as a manager with a proven track record or an offering from a well-regarded fund family.
Individual winners haven't translated to an across-the-board victory for tiny funds. In fact, this year they're doing slightly worse on average than their biggest counterparts, according to
. For the year to date, funds with less than $100 million in assets are down by an average of 2%, while the 10 biggest equity funds are in the red 1.3%, on average. And over the three-year period from 1997 to the beginning of this year, the 10-largest equity funds easily outperformed their tiny counterparts, with average returns of 28.7% vs. 17.1%. So far this year, the average U.S. stock fund, which has assets of $1.1 billion, is up 3.3%.
The picks of the litter offer upside potential that an asset-rich heavyweight simply can't match. In fact, a small asset base may be an advantage in today's market: Many of yesterday's prodigies are so fat with new cash that they're finding it tough to deploy their newly won dollars and equally hard to retreat from sagging stocks. As a result, some of the biggest players have become accidental index funds, because they have to own so many stocks that their performance ends up mirroring the broader market.
Small funds don't encounter that problem. It's far easier for them to bet on up-and-comers, and they can dart in and out of stocks without difficulty. Of course, how an investor measures "smallness" depends in part on investing style. If a fund focuses, for example, on small-cap stocks, the rule of thumb is that it may be getting too big if its asset base is more than $1.5 billion. A large-cap fund, however, can grow as large as $10 billion before it starts encountering mobility problems. (For more on the right size of a mutual fund, check out this
In the case of sector funds -- where the universe of potential investments is limited -- small size is often even more of an advantage. Huge sector funds are likely to have a particularly hard time entering and exiting stocks, and that could hinder performance. For example, it may be difficult for
Dresdner RCM Biotechnology -- one of the year's best performers so far, up 93.3% -- to replicate that fantastic return going forward. The fund, which had a mere $14 million as recently as the end of 1999, has surged to $961 million in assets. That's a lot of money to parcel out within just one sector. However, as this recent
Big Screen notes, there are always standout exceptions.
A look at
-ranked funds suggests there's no shortage of five-star performers with assets of less than $100 million: A random selection includes
Chesapeake Core Growth, with $18 million, up 21%;
Green Century Balanced, with $88 million, up 32.8%;
Phoenix-Seneca Mid-Cap Edge X, with $23 million, up 22.7%; and
MFS Mid-Cap Growth, with $10 million, up 22.9%. Those returns may not look spectacular by last year's standards, but they're well ahead of the pack this year.
Why would a fund have so few assets? Some are relatively new, and simply haven't had time to collect much cash. Others may belong to investment companies that have given short shrift to marketing, so not many investors know about their products. And, of course, some funds with small asset bases simply haven't performed well enough to attract dollars.
Many investors associate small assets-base funds with risk. "Investing in a fund with a very small asset base is comparable to investing in very small operating company of some kind," says John Cassidy, senior analyst at Lipper. "There is a wide range of possible outcomes. There's not just risk in the sense of losing money, but also risk in terms of not knowing
what could happen."
It's true that tiny funds have a harder time attaining profitability. Industry statistics suggest that a mutual fund typically turns profitable after exceeding $50 million in assets. "That's not to say the 2,042 funds with less than $50 million aren't profitable," explains a report from
, "but they definitely have tighter margins."
In the worst-case scenario, a fund with too small an asset base -- whether because of poor performance or other factors -- might be forced to close up shop. That would leave investors stuck with a tax bill for capital gains (even a fund with a capital loss is likely to have accrued some gains). There were 176 fund liquidations through the third quarter of 2000.
Expenses are another potential stumbling block for a fund with an undersized asset base. Typically such a fund has higher expenses, because it's distributing costs among a smaller group of investors. Small-size funds at well-known investment companies sometimes offer better deals, because the companies can absorb some of the costs themselves. (Of course, big names also attract more investors, which in turn boosts assets.) For example,
Flex-Funds Total Return Utilities, with $19 million in assets, charges 1.8% in operating expenses, but
American Century Utilities, with $306 million, charges only 0.7%. The average no-load fund carries operating expenses of 1.44%.
Worth the Risks
But even if it's not dirt cheap, a really good fund may be worth it. Dresdner RCM Biotech charges an expense ratio of 1.5%, notes Richard Del Monte, an investment advisor at the
Del Monte Group
in Danville, Calif. While he doesn't own that particular biotech fund, he's not bothered by its expense ratio. "You wouldn't want to miss out on making a 120%
return by worrying about an extra half-percent," he points out.
In fact, Del Monte likes funds with a small asset base, provided the management is solid. When John Wallace, formerly a respected money manager at
, left to start a new fund at
in 1996 --
RS Diversified Growth -- Del Monte put clients in the fund from the very beginning. (The fund finished its first month in 1996 with a mere $10.2 million in assets; it's since grown to $756 million). Though it's currently down 15.2% for the year, RS Diversified Growth has compiled a solid record since inception, with an annualized three-year return of 31.3%. "People forget that you're hiring a certain manager, and the mutual fund is just a vehicle," says Del Monte.
Besides the reputation of the money manager, investors should pay attention to the track record of the investment company that's running a tiny fund. "If a company's got lots of mutual funds and comes out with a new one, you have a sense for their track record overall, and that gives you a greater degree of confidence," Del Monte explains.
So next time you notice a great performance from a skinny upstart, don't dismiss it out of hand. If a midget-size fund has the right manager and a respected company behind it, it just may be worthy of your cash.