- The Washington Times - Wednesday, July 20, 2005

Wall Street has been predicting a decline in small-cap stocks for the better part of two years, but their cycle of outperformance continues to surprise investors, particularly after the Russell 2000 index reached a new high last week.

The era of small-cap supremacy started in 1998, endured the tech meltdown and has now stretched into a seventh year. For much of this long run, money has rushed into the category, leaving limited choices among mutual funds as dozens of portfolios shuttered to new investors in the face of rising asset levels.

Because cycles like this have historically lasted for five to seven years, some financial advisers have suggested investors collect their profits and head for the doors. Others say strong fundamentals, relatively low interest rates and easy access to debt are still working in the favor of small companies, and the most bullish note that some small-cap cycles have lasted as long as 10 years.

Trying to figure out what’s next for small caps sounds complicated, and it is. For small investors, the best strategy is to figure out what portion of your fund portfolio you are comfortable dedicating to this volatile but rewarding asset class, and sticking with it, regardless of what the market is doing.

“Whether small caps will start to underperform or not is hard to call. We know that at some point they will, but whether it’s next year or three years from now, we can’t say,” said Vivienne Hsu, portfolio manager of the Schwab Small-Cap Equity Investor fund (SWSIX).

Though it’s easy to get distracted by the market’s short-term moves, the least painful way to manage your risk is to maintain your allocation and try not to let greed get in the way, Miss Hsu said. If the Russell’s recent surge to new high of 671.74 gives you the urge to pile more money into your small-cap stake, recognize that you’re chasing performance. If small caps post a precipitous decline and you feel a tickle of panic and yearn to sell, understand that you’re thinking about timing the market, and that chances are you won’t do it well.

“I manage a small-cap fund … and I think about how easy it is to stray from our own research,” Miss Hsu said. “Sometimes we have gut feelings, in small caps even more so. It’s human nature. Having a disciplined approach is really important in small caps. We can’t let our gut feeling sway us from that too much.”

In a diversified portfolio, most financial planners agree small caps should play a side role, accounting for no more than 20 percent of total stock holdings even for the most aggressive investors. People who are nearing retirement or anyone with serious aversions to risk probably would be better off with 5 percent or less.

Once you decide what range is right for you, either on your own or with the help of an adviser, keep an eye on your stake. If it inches up — as it would have over the past five years — take it back down to where you know it should be, and relish the opportunity to profit from your winnings. This sort of thoughtful rebalancing is the key to long-term investing success.

If you are just starting out as an investor, are unhappy with your small-cap fund or just missed the small-cap express, you will have to shop carefully, said Laura Pavlenko Lutton, an analyst at fund tracker Morningstar Inc.

Small-cap managers have faced an unusual challenge over the past several years: They’ve had too much money to invest. When a lot of money flows into a small-cap fund, managers either let their cash stake rise, lower their standards when it comes to picking stocks, or stray into the midcap arena — all of which can have a negative effect on performance. The most common and often the most responsible solution for a manager who has more money than good choices is to close the fund to new investors.

“It’s a challenge. We would all hope the manager of a small-cap fund would be quick to say, ‘My fund is getting too big, I’m having to make compromises, let’s close it down,’” Miss Lutton said. “But you, the investor, really have to keep track of this. You can’t always rely on the fund company to do it.”

How big is too big depends largely on a fund’s strategy, Miss Lutton said, but the question should be considered of any small-cap portfolio with assets of $1 billion or more. If a fund is that large and still accepting new money, it should have low turnover and an experienced manager.

There are still a handful of open funds worthy of consideration, with long-tenured managers, good records, relatively low fees and disciplined strategies. Morningstar’s current picks include:

• Diamond Hill Small Cap (DHSCX). Managers Roderick H. Dillon Jr. and Thomas Schindler, who have led the fund since 2000, favor cheap companies with good prospects and like to ride their winners. Because they aren’t afraid to pile into appealing sectors, this fund may be volatile, but its consistent strategy, low asset base and average expenses make it a good choice.

• Third Avenue Small-Cap Value (TASCX). Like most offerings from this value-focused shop, this fund zeros in on bargain-priced stocks with solid balance sheets. Assets of $1.46 billion make it less nimble than it used to be, but manager Curtis Jensen, in charge since 1997, has a disciplined buy-and-hold approach, and the reasonable 1.14 percent expense ratio helps make it an appealing long-term pick.

• Vanguard Explorer (VEXPX). This isn’t the most adventurous fund, but its diversified portfolio, divvied up among six independent managers, has performed well in a variety of markets. A huge asset base limits its flexibility, but the rock-bottom 0.57 percent expense ratio will turn the head of any bargain hunter.

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