Small funds can offer action, but not always in the right direction

This has indeed been a big year for mutual funds. Big sales. Big numbers of new investors. More big funds. Some funds are very big, like Fidelity's Magellan, at more than $3 billion in assets. Then why do some people keep talking about small funds? Is it just the usual band of contrarians who like to go against the grain? Or do the small funds, managing a relatively puny $150 million to $200 million and less, have a good idea there?

With more than 1,400 mutual funds to choose from, the reasons people select a specific fund vary widely. Some look for certain industries, others look for a management philosophy that fits their own, while others look at size.

Smaller funds, their advocates say, have more flexibility to move in and out of investments than the giants, who have to trade in huge quantities to make a difference. If one or two companies in a small fund's portfolio hit the skids, the fund can pull out without having to sell millions of dollars' worth of stock.

Small-fund advocates also contend that their funds can pay more attention to smaller-capitalization companies, which, the theory goes, have more potential for growth. If a large fund tries to buy a ``small cap'' stock, the money it pours in can drastically affect the price.

``Small funds in general have the advantage of more flexibility over large funds,'' says Norman G. Fosback, publisher of the Mutual Fund Forecaster, a Fort Lauderdale, Fla., newsletter. ``And they do tend to buy more small-capitalization companies.

``It seems to come down to how well a fund is managed.''

That, investment experts say, is probably the most important factor. The success of the huge Magellan Fund in Boston is almost universally attributed to the investment acumen of Peter Lynch, the fund's portfolio manager for the past 10 years. The fund leads the Lipper Analytical Survey's list of top-performing funds for the past five and 10 years, with increases of 230.42 and 1,493.15 percent, respectively. Much of this growth came when the fund was much smaller and, for a few years, closed to new inves tors. Even Mr. Lynch has said that investors who want to make a lot of money now will have to buy a ``much smaller'' fund than Magellan.

To this end, funds like the two Strong Funds, the Acorn Fund, the Charter Fund, and the Ivy Fund have generally had good records in up and down markets while keeping their assets at around $200 million or less.

Another one, the Janus Fund, started out small in 1970 and stayed small for several years, but its success has helped propel it to more than $400 million in assets, calling for different management techniques and, recently, two new funds.

``When a fund grows from $40 million to $400 million, obviously it requires some changes in management,'' says Thomas H. Bailey, president of the fund. ``Instead of 30 or 40 stocks, you now have to deal with 100 stocks or more.''

Mr. Bailey wanted funds that ``could be sort of what Janus was in the early years,'' so he recently opened the Janus Venture Fund and the Janus Value Fund. Each has about $5 million in assets, and Bailey hopes to keep them fairly small.

Much of the attention on small funds began earlier this year when Gerald Perritt, publisher of the Mutual Fund Letter in Chicago and president of Investment Information Services, did a study comparing the performance of small and large funds.

The study looked at the records of 70 diversified no-load equity funds from 1979 through 1984. Each fund's annual result was compared with its assets at the end of the preceding year, to give an annual performance record. These performance records were then grouped into five categories based on asset size.

The smallest group, with assets of less than $19.8 million, had the highest median return, at 25.2 percent. The second-highest group, funds between $19.9 million and $37.7 million, had the second-highest return, with a median gain of 21.3 percent. The trend continued up through the largest group of funds, those between $182.2 million and $1.66 billion, which had a median return of 13.1 percent.

``A small fund can dip and dart more easily,'' Mr. Perritt contends. ``If a $50 million fund wants to go 30 percent cash, it can do it by selling $15 million in securities. A $2 billion fund has to sell $300 million of securities. And the transaction costs are far less for a $10 million trade than a $300 million trade.''

``This doesn't apply to bond funds,'' he added. ``With these, the bigger the better, because you really want that diversification.''

Perritt agrees that the right manager has as much to do with the success of any fund as size, and may often be more important.

``My hero in the industry is Peter Lynch,'' he said. ``But he admits size can be a detriment. Once you get down to a handful of top funds, the most important criterion is management.'' With so many funds having been created in the last couple of years, he adds, ``there are many fund managers who have only known a bull market.'' Look for managers who have had to face a couple of major market downturns, he recommends.

The flip side of being able to make bigger gains with a small fund, of course, is the increased risk of losing money if some of the high-flying stocks in your fund take a tumble. If two stocks in a portfolio of 30 fall, it's going to have a more dramatic effect than if those two stocks are part of a group of 300.

``Small funds may be more volatile and more apt to exceed the market in either direction,'' points out William J. Goldberg, national director for personal financial planning at Peat, Marwick, Mitchell & Co., the accounting firm. ``Sometimes, when a fund gets large, it will close and start a new fund with similar objectives.''

That's what the Vanguard Group did with its Windsor Fund, last year's best-performing diversified equity fund. The fund was closed to new investors in May and a new fund, Windsor II, opened a few months later.

Windsor II, however, is not managed by Vanguard's John Neff, who is credited with the original Windsor Fund's success. Instead, Vanguard has selected an outside management company to handle the new fund. It remains to be seen if Windsor II will perform as well -- or be as popular -- as its younger brother.

Size, then, seems to be only one criterion in selecting a fund. Other factors to consider are the stocks in the portfolio, whether or not the fund is fully invested, and how often the fund buys and sells stocks. Then there's the track record of the manager. If you find an outstanding manager, he or she will probably do a more effective job with a small fund.

On the other hand, if the fund manager retires or is lured away, you may want to move, too. You won't have to go immediately; it takes while before a new manager affects the price of the fund.

of 5 stories this month > Get unlimited stories
You've read 5 of 5 free stories

Only $1 for your first month.

Get unlimited Monitor journalism.