According to — well, just about everyone — it’s nearly impossible to beat the Standard and Poor’s 500 stock index for any prolonged period of time on sheer cunning alone. Those who do may owe more to chance than to skill. And for that reason, your best investment bet is a low-cost index fund, such as the ones in the Amish Portfolio.
If there is any hope for active management, it’s in small markets where 1,000 analysts aren’t looking at each stock — such as small and micro-cap companies. The problem with small companies is that they have an unfortunate tendency to become much smaller companies, at which point they become former companies. And many small-company stock funds have to sell small companies when they become too large. Imagine if you had done that with Apple.
Nevertheless, if you’re hoping to get a boost from active management, small-cap funds are probably the place to look. And small-company value funds, which look for unappreciated and cheap companies, might be the best part of of the small-cap universe to look. One of the many questions about looking for a small-cap fund: Is the fund performing well because it’s taking outrageous risks?
Fortunately, there’s a stat for that, and it’s called alpha, which measures a fund’s return in relation to the risk it takes. A fund with an alpha greater than 1 gives off more return than one would expect, given the risk.
Risk, in this case, is determined by beta, which measures how a fund relates to an index, such as the Standard and Poor’s 600 small-cap index. A fund with a beta of 1 runs in lockstep to its index. One with a beta below 1 will rise or fall less than its index; one with a beta above 1 will rise and fall more. Basically, you want a fund with an alpha above 1 and a beta below 1.
Finally, you want a fund that’s not too large. Most funds won’t buy more than 5% of a company’s outstanding stock. Small-cap stocks, by definition, have about $1 billion or less in shares outstanding. Suppose a fund liked a stock whose outstanding stock was worth $500 million. The fund could buy a maximum $25 million of the stock. If the fund had $2 billion in assets, the position would be just 1.25% of the fund’s assets — a relatively small stake.
So: If you’re looking for a small-cap value fund that actually adds value, look for one with an alpha greater than 1, a beta less than 1, and assets less than $1 billion or so. And if these managers are truly cunning, consider selling them if the rest of the world catches on. Sooner or later, their success will translate into higher assets, and that, in turn, will make it harder for them to succeed.
Some caveats: The S&P 600 small-cap index has risen an average 15.42% the past three years, and small-company value funds typically lag in a red-hot small-cap market. This has been the case recently: The average small-cap value fund has gained 13.17% during the same period. It’s usually best to buy small value after a market meltdown, so there’s clearly no hurry. And several of these funds are microcap funds, which invest in companies small enough to fit into a mouse’s teacup. With all that in mind, here’s the list.
|Fund||Ticker||Total return 2015||Total return (annualized) 3 years||Alpha||Beta|
|James Micro Cap||JMCRX||7.3%||21.3%||7.00||0.96|
|Ancora MicroCap C||ANCCX||-3.4%||15.8%||3.44||0.92|
|Emerald Small Cap Value Institutional||LSRYX||3.8%||15.0%||2.91||0.92|
|Great-West Invesco Small Cap Value Init||MXSVX||-0.6%||14.8%||2.44||0.97|
|Perritt Ultra MicroCap||PREOX||-1.1%||14.7%||5.42||0.55|
|Ancora Special Opportunity C||ANSCX||-1.0%||13.9%||1.90||0.86|
|Nationwide Bailard Cognitive Value M||NWHFX||2.2%||13.6%||2.20||0.92|
|Queens Road Small Cap Value||QRSVX||2.8%||13.1%||4.06||0.70|
|DGHM V2000 SmallCap Value Instl||DGIVX||1.2%||12.4%||1.57||0.89|
|Small Cap Value||SCAPX||-13.6%||7.9%||7.99||0.93|
|Cozad Small Cap Value I||COZIX||-6.6%||0.0%||1.44||0.96|