| "In real life, unlike in Shakespeare, the sweetness of the rose depends upon the name it bears." |
| -- Hubert H. Humphrey |
HE PAST SEVERAL YEARS
HAVEN'T BEEN KIND TO value investors. Growth handily outperformed value
throughout the decade of the '90s. Investors in small stocks also suffered in
comparison to those holding large stocks. But the worst performers had to be the
combination -- those who bought small value stocks.
Just like anything else, not every small value investor suffered equally. Many had low single digit returns while some even had a few negative years thrown in. Yet other small value portfolios had sparkling returns. Was this good stock-picking or the result of something else?
Unfortunately, for the most part, it was something else. You see, not all small value investors are created equally -- primarily because some aren't small value investors. To see what this means, you only have to look a little closer at the way some of the best returns were achieved.
While you can't examine most individual investor's portfolios, you can look at their proxy -- mutual funds. To see how some of the best small value results were achieved, we decided to check out some of the best funds in that category. What we found was a little surprising.
Playing the Numbers
We used the Lipper data as reported in the Wall Street Journal Interactive's Small-Cap Value Scoreboard, and focused on the best one-year performers for the twelve months ending April 5, 2000. During this period, there were 263 funds in the small cap category. The average return (following an excellent first quarter of this year) was 22.5%.|
|
||||||||||||||||||||||||||||||||||||||||
|
||||||||||||||||||||||||||||||||||||||||
Up at the top of the list was a fund with a 153.0% return. Of course it had only been around for a little over a year, so we didn't spend a lot of time with it. Instead, we decided to concentrate on funds with at least a five-year track record.
The nearby table shows the top five funds meeting our screen. Each returned at least 100% over the category average. Here's how they did it:
Grow Value
Last year, one way to keep up with growth funds and surpass value funds was to become a growth fund. Apparently, that's what Mercantile Small Cap Equity did.|
|
 Source: Ibbotson Associates When the funds are plotted based on their style (growth/value) and capitalization (large/small), Mercantile Small Cap Equity looks like a growth fund and Meridian Value looks like a mid-cap fund. Neither looks like small value. |
With the help of Ibbotson Associates, we regressed the performance of our five funds against large and small cap growth and value indexes. The Russell 1000 and Russell 2000 Growth and Value indexes served as proxies. The resulting plot (shown on the nearby graph) shows the characteristics of each fund.
As you'll notice, Mercantile Small Cap Equity falls squarely in the "growth" quadrant. If you can't beat 'em, join 'em.
Think Big
From the same plot, you can also see that Meridian Value really isn't a small cap fund. Since the graph shows the smallest capitalizations at the bottom|
|
 Source: Ibbotson Associates As of December 31, 1999, Meridian Value held less than 50% small cap stocks. The rest were mid and large caps. While over 85% of Mercantile Small Cap Equity was in small stocks, over half of the fund was in growth stocks. Neither really looked like a small cap value fund. |
When small caps are struggling, you can improve your performance if you buy something else, in this case it was mid-caps.
Go with the Flow
When we first looked at each fund's asset mix, we were extremely impressed with Royce Opportunity. Here, finally, was a value fund holding value stocks. In fact, as the accompanying rolling style chart shows, as of December 31, 1999 this was almost a pure Russell 2000 value portfolio.But then we took a closer look at the graph. Rolling style is a graphical means of tracking portfolio composition over time by assigning a specific color to each benchmark. Each vertical slice of the graph shows how the portfolio was composed at that particular time.
As you'll notice from the accompanying graphs, Royce Opportunity started 1999 holding 65-70% large cap value. When small caps began to assert
|
|
 Source: Ibbotson Associates Although a fund may hold small value stocks now, there's no telling how long it has. These rolling style graphs show how three of the top performers gained their crowns. Not a lot of small cap value consistency here. |
Tocqueville Small Cap Value took a similar tack but instead of using large cap value in early 1999, used small cap growth. Yet the prize for the greatest disregard for the fund's objective goes to Merrill Lynch Special Value. It started 1999 with an even mix of small cap value and growth, but had spent the prior two years with nearly 100% small cap growth. How's that for going with the flow?
Other Tools of the Trade
Actually, what these funds did to achieve their top rankings was pretty tame compared to what other managers do. Here are several things they didn't do:- Go IPO -- Many small cap funds bet big bucks on IPOs, hoping to
quickly sell them when they spike immediately after coming public. This was
usually a winning strategy in 1999, but now with the market more volatile
and uncertain, it may not work as well. Even when it does, it injects a lot
more risk into the fund since it really isn't investing, it's gambling.
- Want More Return? Add More Risk -- One of the first things
investors learn is there's a direct relation between risk and return. When
managers feel the need to increase return -- especially in the short-term --
they often move into more speculative stocks or (as mentioned above) IPOs.
But as you can see from the first chart on this page, our five funds really
didn't do this since with the exception of Mercantile Small Cap Equity, each
has a relatively high Sharpe Ratio. (For more details on the Sharpe Ratio
and how it's used to measure risk adjusted return, see Like Tech? Buy Energy in the Archives.)
- Small Fund, Big Gain -- Little things mean a lot to small portfolios. Managers of small funds only have to find one or two really big winners to have their returns take off. On the other hand, the larger the fund, the lesser the impact any holding will have -- unless it's so overweighted it becomes a major risk. As a result, some of the best returns are often turned in by some of the smallest funds. While none of the five funds we considered was overly small, several funds that "outperformed" them were. For instance, one with a 59.1% one-year return had $3.3 million in assets while another with a 52.8% return was just $900 thousand. How reliable is that information?
Why It Matters
At this point you might be wondering why all this matters. After all, isn't the return what's important, not how it was achieved? It's the gains you put in the bank, not the portfolio's style purity.True enough, but there's more to it than that. The reason these purported "small cap value" funds did well was because they did something besides invest in small cap value stocks. Whether they used large cap stocks or small cap growth stocks, they got a good return, there's no denying that.
But when you pick a fund, or a manager, or an investment style, you're doing it for a reason. Maybe you want a fund that invests in small caps because you already have another portfolio holding large cap stocks. Or maybe you're a growth investor seeking diversification with a value fund. If the manager you choose doesn't stick to his or her stated style, you're not getting the portfolio you sought. Sure, you might do OK when the manager drifts in the right direction, but you're probably duplicating other parts of your portfolio. And if the manager drifts the wrong way, you'll be really disappointed when you don't get the benefit of the objective you thought you chose.
Funds that don't stick to their objective also reflect poorly on those that do. In this case, our five "small cap value" funds outperformed the majority of those that really held small cap value stocks. If you owned a real small cap value fund, you might be tempted to switch into one of them. You might feel your manager -- rather than small cap stocks -- under performed.
You can't just count stars and look at numerical rankings. Like so many things in life, you have to look closely to determine if what you see is what you get. When it comes to mutual fund and portfolio performance, it usually isn't.
Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
|
|||||||||||
| Homepage | Return to Top |
