Reopened Small-Cap Funds Await Rebound

The Wasatch Small Cap Growth (WAAEX) mutual fund started accepting new investors in the spring for the first time in seven years. Since then manager Jeff Cardon has felt like a poker player whose strong hand is frustratingly beat on the river card. "I own what I think is a stable group of companies, but these stocks have gotten hammered," he says. "It will make more sense in eight or nine months when things settle down."

This fund is 45.2% lower this year, putting it near the middle of the small-cap pack. That's not exactly what Wasatch had in mind when it reopened the fund in March. Then, Cardon was seeing a lot of good stocks trading at discounted prices while Wasatch, a firm known for decent fees, disciplined strategy and for being shareholder-friendly, thought a new group of investors could participate in a fund that had been a perennial top performer for over a decade. It hasn't quite worked out that way — at least not yet.

According to Morningstar, 75 funds holding around $230 billion have reopened their doors to new investors in 2008. That trend, which we anticipated over a year ago, has spread to every corner of the mutual-fund world, including Fidelity, which reopened the flagship large cap fund  Magellan (FMAGX) in January and will soon open Contrafund (FCNTX) and Low-Priced Stock (FLPSX) to new money, too.

Nowhere, though, has it been more pronounced than in the small-cap arena. Thirty-five reopened funds, accounting for almost 12% of that $230 billion, focus on the stock market's tiniest companies. While the results of these openings have been spotty so far, managers, financial advisors and industry watchers think these small-cap funds may be setting themselves up for a nice run in 2009.

If that happens it would follow in line with both short- and long-term historical patterns. Ibbotson Associates, the stock market data firm, found that small-company stocks have outperformed large-cap ones on an average annual total return basis since the Great Depression. More recently, small-cap stocks enjoyed a four-year run after the last bear market earlier this decade.

In 2006, though, that situation started to turn. The rally showed signs of cooling off and investors started putting their money in cheap large caps or in overseas funds. Meanwhile, many small-cap funds closed in order to avoid becoming victims of their own success. An excess of cash can actually handcuff a small-cap manager. He runs the risk of artificially popping the price of a stock as he builds his position, or he's forced to put the money to use in stocks he doesn't have a a lot of conviction in.

The small-cap reversal gained speed in 2007 with the subprime mortgage crisis. Small-cap funds had already fallen behind. Now, however, the stocks they owned were getting pummeled. At the same time, the closed funds were dealing with a nasty problem: redemptions. Exiting shareholders, whether retirees or younger shareholders looking for safer harbors, have to be cashed out by the fund. If a manager isn't sitting on cash, he must sell stocks to make them whole. Selling under those terms can force a manager to part with stocks he doesn't want to or, worse, trigger capital gains.

When the first quarter of 2008 rolled around, closed small-cap funds were in a predicament. At the same time they were watching money head for the exits, they wanted assets to buy stocks that were trading at amazingly cheap levels. "Small-cap fund mangers realized there were opportunities before the public did," says Adam Bold, founder of The Mutual Fund Store. The fix: Reopen to new investors.

The timing seemed perfect. Funds from shops like Third Value, Allianz, Royce, Wasatch and Century welcomed thousands of new investors. Through the first half of the year they did reasonably well. In late July the small-cap category was down an average 10%, about four percentage points better than the broad market. There was lots of chatter these funds would lead investors out of the downturn.

Of course, nobody could have anticipated what was to come. September saw the demise of some of Wall Street's biggest names. Investors fled equities and got into cash or bonds. Small-cap investors measure stocks, in part, on their ability to borrow capital, potential M&A deals and growth prospects above the market average. When all that either dried up or was called into question during the fall, small-cap funds took on another layer of uncertainty. According to Lipper, the average small-cap fund has now lost 44.3% year-to-date through Friday vs. 41.4% for the average S&P 500 index fund.

"Small caps are fast growers and trade at higher valuations," says Kevin Callahan, manager of Century Small Cap Select (CSMVX). "In times of uncertainty, though, they tend to take it on the chin more than large-cap companies because those companies have less volatility."

Market watchers remain optimistic. A Citigroup report dated Dec. 4 projected the Russell 2000, a standard benchmark for measuring small-cap stocks, would end 2009 at 550, a 25% uptick from the report's publication date. "While our analysis is not calling for a clear shift into small-cap stocks just yet," the report said, "we continue to believe the stage is being set for such an inflection point in 2009."

If, indeed, that is the case, the raft of reopenings gives investors a wide array of choices they didn't have 12 months ago. "[The category] has been void of good options," says Elliot Herman, who overseas asset management for PRW Associates in Quincy, Mass. Now, though, "we have been able to add to our lineup."

The 35 small-cap funds Morningstar says opened their doors in 2008 — click here to see a spreadsheet — have lost an average 12% each of the last three years, but charge a below-average 1.28% annual expense ratio and feature long-term earnings growth rates of 14.9%. Shana Orczyk, a research analyst with Peak Financial Management in Waltham, Mass., says her firm is comfortable with a 6% to 10% portfolio exposure to small caps. "These funds have a valid place in everybody's portfolio," she says.

We would narrow that universe to a few funds that include Third Avenue Small-Cap Value (TASCX), Callahan's Century fund, Wasatch Small Cap Growth and Allianz NFJ Small-Cap Value (PCVAX). Callahan's Century fund used recent dips in the market to pick up shares of RalCorp Holdings (RAH), a maker of private-label food stuffs and recently the purchaser of Post cereals from Kraft Foods (KFT). The Allianz NFJ fund counts Casey's General Stores (CASY), Owens & Minor (OMI) and Bemis (BMS) among its top holdings. All these funds have proven managers who have navigated tough markets in the past. We think these reopened funds will do well once the market regains some confidence.

"Nobody thinks [this category] is going to turn on a dime," says Bridget Hughes, a fund analyst at Morningstar who follows small caps. "If you look at the long term [small caps] have been better performers. You can buy them cheaply now and wait for them to take off again. The big question is when will that happen?"