They’re Not As Risky As You Might Think

Mutual funds that invest in stocks of small companies can boost your long-term portfolio returns—but if you choose the wrong ones, they may cause you a lot of sleepless nights. Small-cap funds have outperformed large-cap funds on average over the past five-, 10- and 15-year periods. However, they also have experienced much greater volatility, typically falling 25% more than large-cap funds in down markets. And in 2014, they took investors on a wild ride before finally eking out a gain of less than 4% for the year, compared with 11% for large-cap funds.

So how big a role should small-cap funds play today in your investment portfolio, and which funds will likely fare best if there are rough times ahead? That’s what we asked mutual fund ­analyst Todd Rosenbluth…

WHAT TO EXPECT

The overall stock market is facing more volatility in 2015 than in recent years, as nervous investors worry that the Federal Reserve will finally start to raise short-term interest rates. But that doesn’t mean you should avoid small-cap funds.

I don’t foresee deep or lasting pullbacks this year for small-cap stocks. In fact, small companies could do relatively well this year. That’s because, unlike many large companies, most small companies get their revenue mainly from the US rather than exports, and the US economy, though hardly on fire, is doing very well compared with the economies of many other major countries. The US economy is expected to grow 3.4% in 2015, its fastest pace since 2005.

The key is to find steady small-cap funds that curb excessive volatility enough that you can stick with them through ups and downs.

What I look for…

• Experienced managers who use a ­reliable, disciplined stock-picking style that has worked in the past and can work in the future.

• Low beta. A fund’s beta measures its volatility compared with that of the overall stock market. It captures the fund’s sensitivity to market swings, typically against a benchmark like the Standard & Poor’s 500 stock index. The higher a fund’s beta, the more volatile it has been relative to the index. For example, if a small-cap fund has a beta of 1.25, that means whenever the S&P 500 moves up or down 10%, the fund is expected to swing 12.5%. You want funds with betas around 1 or less, indicative of similar or lower volatility compared with the S&P 500.

• Top long-term returns. Don’t sacrifice performance for safety. A small-cap fund that takes few chances can have a very low beta…but mediocre returns. Focus on funds that have had returns that rank high among their peers and that have beaten the S&P 500 over the past several years.

MY FAVORITE SMALL-CAP FUNDS

Small companies—those that have a stock market value of $2.5 billion or less—make up about 10% of the overall stock market, so that’s a good starting point for your own portfolio allocation. Aggressive investors may want to have greater exposure and conservative investors less.

The five no-load mutual funds below are all rated four or five stars by my ­research firm, S&P Capital IQ. The funds for moderately aggressive investors tend to be slightly more volatile than the S&P 500, but their superior returns can make them worth a bit more risk. The ones for conservative investors have about the same volatility as the S&P 500 or less, so over time you get better performance without taking on any additional risk…

Moderately aggressive investors… 

• Brown Advisory Small-Cap Fundamental Value Fund (BIAUX) looks for companies that generate strong cash flow year after year and have little or no debt. Their stock prices are low ­either because they are misunderstood or overshadowed by sexier, faster-growing companies. In fact, the fund has a knack for selecting businesses that get taken over by larger companies at significant premiums to their share prices. Recent top holdings: Convenience store distributor Core-Mark…Broadridge Financial Solutions, which provides back-office processing for banks and brokerage firms. Fund performance: 19%.*

• Pax World Small Cap Fund (PXSCX) proves that investing with a conscience can provide top returns even in the small-cap category. This socially responsible fund doesn’t just avoid “sin stocks,” such as companies that provide alcohol or benefit from gambling. Manager Nathan Moser searches for companies that are highly profitable but also encourage diversity in the workplace and improve the quality of life in communities in which they operate. The fund reduces risk by trimming back each stock as soon as it reaches what Moser considers fair value…and investing the proceeds in a more undervalued security. Recent top holdings: Capitol Federal Financial, a 120-year-old community bank that is one of the top lenders in the state of Kansas…Hologic, a manufacturer of diagnostic and surgical products for women’s health care. Fund performance: 17%.

• Wasatch Core Growth Fund (WGROX) invests in about 60 companies that fund manager J.B. ­Taylor expects to deliver steady earnings growth of at least 15% a year despite the economy’s ups and downs. Taylor likes to make the occasional bold pick if he thinks it will pay off, such as a biotech or cloud-computing company, but he mostly sticks with high-quality growth stocks and hangs on to winners even as they turn into medium-sized companies. Recent top holdings: Copart Inc., which auctions vehicles over the Internet…discount airline Allegiant Air…and marketing-services company Cimpress. Fund performance: 18.5%.

Conservative investors…

• Mairs & Power Small Cap Fund (MSCFX) is a young fund, launched in 2011, with an intriguing pedigree. It uses the same buy-and-hold process as its low-volatility, multicap sibling, the Mairs & Power Growth Fund, which has beaten the S&P 500 over the past 20 years by an average of three percentage points annually. Over the past three-year period, the small-cap fund ranks in the top 1% of its category. It invests two-thirds of its assets in companies headquartered in the Midwest, so the fund managers, based in St. Paul, Minnesota, can easily visit and get to know top management. The fund leans toward well-run industrial and technology companies that have long-term competitive advantages in their industries. Recent top holdings: Cray, which makes supercomputers for clients such as the Mayo Clinic and the US government…Gentherm, a manufacturer of heated seats for the automobile industry. Three-year ­performance: 20.5%.

• Value Line Small Cap Opportunities Fund (VLEOX) has a well-­diversified portfolio of 100 to 120 small-cap growth and value stocks based on the ranking system created by its venerable parent, the investment research firm Value Line. The system, which is designed to reduce volatility while boosting performance, considers only companies with a record of 10 years or more of consistent earnings and stock price growth. Recent top holdings: Commercial cookware manufacturer Middleby Corp…LED lighting maker Acuity Brands…and Lennox International, a global supplier of climate-­control products. Performance: 18%.

*Performance figures are annualized returns for the five years through February 28, 2015, unless otherwise noted.

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