Now You See It...

mall cap equity funds, particularly those with a value tilt, are a fundamental component of a well designed equity portfolio. The trick is finding ones that are for sale.

Indeed, small cap U.S. equity funds that have a track record of at least 10 years and which have no purchase constraints are surprisingly rare. For instance, there were 1,436 small cap U.S. equity funds in the Morningstar universe as of October 31, 2004. Of that total, only 421 had ten years of performance history. In light of the turbulence of the U.S. equity market in recent years, a ten year history is sufficiently long enough to provide a measure of performance in both good and bad times.

From that sub-total of 421 funds, 80 funds were categorized as small cap value, 131 as small cap blend, and 210 as small cap growth (Figure 1). Understandably, some funds drift between the Morningstar style (and capitalization) boxes over time. In this study, each fund was categorized by its current style box .

Of the 80 small cap value funds, 34 had some sort of purchase constraint. The Morningstar "Purchase Constraints" nomenclature is as follows: closed to new investments (C); closed to all investments (L); institutional shares (T); qualified access (A). Conversely, 46 funds were purchasable by the common man (i.e. had no purchase constraints).

For ease of discussion, funds which have no purchase constraints will hereafter be referred to as "available" funds and those with purchase constraints as "constrained" funds. In the Morningstar database, funds which have a "qualified access" constraint are only purchasable through a financial intermediary (broker, financial advisor, trust department, etc.). Of the 46 available small cap value funds, only 22 were distinct portfolios. Among funds with multiple share classes (which all share the same portfolio) a "distinct portfolio" in this analysis was the share class with the largest net asset base. Thus, from a total starting number of 313 small cap value funds, there were only 22 available, distinct portfolios with a ten year performance history -- a mere 7% of the total number of U.S. equity small cap value funds.

Among small cap blend funds, only 42 out of the entire sample of 431 were available, distinct portfolios with a ten year history - which represents just under 10% of the total number of small cap blend funds. Among the total sample of 692 small cap growth funds, only 7% (or 49 funds) were available, distinct portfolios with a ten year history.

From a starting number of 1,436 U.S. equity small cap funds there were only 113 distinct, available small cap portfolios with at least ten years performance history. This represents less than 8% of the starting number of small cap funds.

In addition to the short supply of available, small cap funds with a ten year history, there are some notable differences between constrained funds and available funds. Available funds in the small cap sector (Value, Blend, and Growth) had lower 10 year annualized returns in each of the three style boxes (Figure 1).

The average 10 year annualized return (12.9%) for the 22 available, distinct small cap value funds with at least 10 years of performance history was 80 basis points lower than the average return of the 17 distinct, constrained funds. In the blend and growth style categories the average 10 year return differential was 150 basis points and 140 basis points respectively in favor of the constrained funds.

Constrained funds also have lower expense ratios in comparison to available funds. The differences ranged from 40 basis points to 62 basis points among the three different small cap style boxes. Moreover, in each style box, the differential in performance is greater than the differential in expense ratio. This suggests that the superior performance of constrained funds - on average - is due to variables other than simply having a lower expense ratio. Small cap funds that are constrained, in some fashion, tend to have superior performance above and beyond the impact of lower expense ratios.

Another substantial difference between available and constrained small cap funds is the initial investment requirement. Among small cap value funds, the median initial hurdle for available funds was a meager $1,000. For constrained small cap value funds the median figure was $1,000,000. Small blend and small growth funds also had sizeable differentials in the initial investment requirement, though not as large.

Eventually, the discussion turns to the obvious question "Okay, so what funds are the best of the rest?" In other words, of the available small cap U.S. equity funds, what are some of the better choices? In Figure 2, the top 10 available small cap value are listed (as of October 31, 2004). The ranking was determined by the summation of each fund's 3, 5 and 10 year annualized return, after which the funds were ranked in descending order by the summed returns. For example, the sum of the 3, 5, and 10 year returns for the Alpine U.S. Real Estate fund was 85. The sum of returns for the next fund (Heartland Value Plus) was 53.30, and so on.

Figure 3 lists the top 10 available small cap blend funds and Figure 4 the top 10 small cap growth funds. The "shelf-life" value of the information in Figures 2-4 is short. Any of the currently available funds could, in theory, close at any time or have some other type of purchase constraint put in place. This "risk" is particularly true in the small cap value category.

Finally, the "performance filter" of this study was changed (i.e. relaxed) to include small cap funds with at least a five year performance history as of October 31, 2004. There were a total of 970 small cap funds with a five year performance history (up from 421 with at least a ten year history).

The top 50 funds, when ranked by 5 year return, are shown in Figure 5. Redundant share classes were removed from the listing of funds in Figure 5. However, in many cases, funds can have as many as six different share classes. And, in some cases, some of the redundant share classes of a particular fund are constrained and some are available. In such cases, two share classes of that particular fund were retained in the table: the available fund with the largest net assets and the constrained fund with the largest net assets.

Of the 50 top performing small cap U.S. equity funds over the five year period ending 10/31/04, only 15 are available. Thus, we can look at a large number of small cap funds, but can only straight-forwardly touch 30% of them.

This analysis leads to an odd idea: perhaps there should be two performance comparisons for investors. One comparison is a measure of their fund's performance against all similar funds. The second comparison is a measure of their fund's performance against all similar available funds. After all, if the performance comparison leads to portfolio changes it is only the subset of available funds that are relevant alternatives.

If one can't touch it, maybe it shouldn't be looked at.

Figure 1. The Small Cap Disappearing Act

* Among funds with multiple share classes (which all have the same portfolio), the “distinct portfolio” is the share class with the largest net asset base.  

Figure 2. Top 10 Available U.S. Equity Small Cap Value Funds with a 10 year Performance History (as of 10/31/04).

Figure 3. Top 10 Available U.S. Equity Small Cap Blend Funds with a 10 year Performance History (as of 10/31/04).

Figure 4. Top 10 Available U.S. Equity Small Cap Growth Funds with a 10 year Performance History (as of 10/31/04).

Figure 5. Top 50 Small Cap U.S. Equity Funds with 5 year Performance History. Available Funds highlighted in Yellow. Ranked by 5 Year Return as of 10/31/04.

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine.

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Erin Farr is an undergraduate student at Brigham Young University specializing in Family Finance.