Some Top Small-Cap Funds May Soon Reopen

Such a shift would jibe with the prevailing sentiment that the small-cap bull cycle is winding to an end. During the years-long run, money poured into small-cap mutual funds so quickly that many managers turned away investors. But so far this year, net cash flows for small-cap funds are in negative territory in a sharp turnabout from 2006, and last month marked the first September in the past three years that fewer small-cap funds were closed.

Year to date, small-cap funds have net outflows of $7.02 billion, compared to net inflows at the same point last year of $9.31 billion, according to Morningstar. In comparison, large-cap funds have net inflows of $3.19 billion so far this year, down from $39 billion in 2006.

"It's a natural response to the disappointing returns small caps have compiled this year," says Jeff Tjornehoj, a senior research analyst at fund-tracking firm Lipper.

Tjornehoj says some investors weighed their portfolios in small caps too heavily too late, and the outflows could be a sign that they're re-allocating their money. "I wouldn't be surprised if those outflows continue to pile up over the next several months given that the momentum seems to be in large caps' favor."

More small-cap funds are still closed to new investors vs. large-cap funds. This generally tends to be the case because small-cap funds invest in stocks with smaller public floats, so they have fewer shares to buy and are less liquid. As a result, many small-cap managers close their funds off after they have a few hundred million or so under management.

But in September, while the total number of small-cap funds increased, the number of funds closed to new investors fell to 200, or nearly 12% of the total. In 2006, 225 funds were closed, or about 14% of the total.

The decrease is the first September decline in the past few years. In September 2003, 7% of small-cap funds were closed to new investors, rising to 10% the next year and nearly 11% the year after that.

"There has been a lot of volatility with small caps, so people might be realizing that they're not willing to take on as much risk," says Bridget Hughes, a senior fund analyst at Morningstar specializing in small caps. Even better, it's a sign that investors are rebalancing their portfolios, although that doesn't necessarily mean more small-cap funds will reopen right away, Hughes says. "The time when small-cap funds start reopening should be when we are in a little more of a down market than we have been."

The benchmark Russell 2000 index has gained about 3% year to date, lagging the large-cap S&P 500, which is up 6% as of Monday's close, and the Dow Jones Industrial Average, which has gained 9%.

Katherine Gallagher, a portfolio officer at Standard & Poor's, says she has heard from some small-cap fund managers who are considering opening funds that have been closed to new investors, which is "kind of what we've been hoping for, because many strong managers have closed their doors."

"A lot of people now are re-allocating away from small cap and rotating back to large cap," Gallagher says. "Small caps have had a really good run, and it's coming toward the end of a cycle."

Eric Cinnamond, portfolio manager of the Intrepid Small Cap fund (ICMAX), which is open to new investors, says overall assets to small-cap funds have tripled since 1999 to upward of $300 billion. "In 1999, no one wanted small caps back then, it was so easy to find [cheap] stocks," Cinnamond says. But the huge asset shift to small-cap funds "is one of the reasons small caps are so expensive" and why more small-cap funds are closed, he says.

Lipper's Tjornehoj says that despite early signs of the turning momentum, it will take some time before the best small-cap funds feel any pinch. As of now, four out of the top-10 best-performing small-cap funds according to Lipper are closed. "It may take an extended period of large-cap outperformance and further drains on small-cap fund assets before many of the best ones lift the velvet rope to new investors."

Few market watchers recommend flooding the gates of most small-cap funds in the current market. But if more velvet ropes are lifted, investors looking to balance out their portfolios might want to get in while they can.