In The Hunt For Top Mutual Funds, Don't Ignore The Little Guys

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In searching for top mutual-fund companies to invest with, don't ignore the little guy.

The best-performing small firms often do better than similarly high-ranking large firms, regardless of whether they own small-cap, midcap or large-cap stocks or follow a value or growth investment style. Forty percent of money managers in the top 25% of their peers have less than $2 billion in total assets under wraps, according to research from financial-services firm Northern Trust Corp. (NTRS)

For investors, the message is that giving money exclusively to industry giants shuts out a large group of talented stock pickers. Broadening horizons to include small firms boosts the odds of finding innovative managers with results in the top 25% of their peers, says Ted Krum, a vice president at Northern Trust who helps institutional clients with money-manager searches.

"If you know how to pick good managers, then look at the small-manager universe because that's where you'll get the biggest bang for your buck," he said.

New research Krum expects to release this fall looked at results over five years through 2006 for managers investing in small-cap and midcap stocks. It found that among firms in the top 25% of their class, the smallest players, handling less than $1.4 billion, delivered returns almost two percentage points better than the giants.

Tiny investment shops returned 16.5% annualized on average in the period, which covered both bull and bear markets, while firms of $1.4 billion to $17.9 billion in size averaged competitive 16% gains, the forthcoming research says.

Performance slipped as assets grew, the study reports. Midsize firms with $17.9 billion to $66.5 billion gained 15.6% on average, while the biggest outfits, managing $66.5 billion to $785.4 billion, posted average gains of 14.7%.

On the flip side, however, bigger firms evidently have a slight edge. The worst small firms, with a 3.5% average gain, underperformed the worst giant firms' 4.2% return in the study period.

Recurring results

The analysis advances a 2006 Northern Trust research paper in which top small managers investing in midcap and large-cap stocks outdid their top-finishing larger counterparts. This pattern has repeated itself in several updates since Krum's original 1995 study.

Small managers bring other advantages over larger organizations, Krum's work suggests, including the ability to protect their investors better in down markets. These managers can be agile when buying and selling stocks, so they may be better able to ride bull runs and sidestep a bear's swipe.

Bigger firms, in contrast, trade huge share volumes that impact stock prices daily across the board; these tankers can't easily change course.

"When you invest with a big firm, you are the market," Krum said. "If the market is going down, you can't get out of your own way."

Moreover, emerging firms tend to be more entrepreneurial and independent-minded — qualities their owners acknowledge.

"Having a small number of assets gives you the ability to be more flexible in the investments you choose," said Robert Killen, chief executive of Killen Group in Berwyn, Pa., which runs about $600 million, mostly in its Berwyn funds.

"We can get in and out of a position in one day," added Don Hodges, whose Dallas-based Hodges Capital Management oversees about $700 million in the Hodges Fund (HDPMX) . "Some funds might take two weeks."

Standouts in the crowd

When choosing among smaller firms, take a page from institutional investors. Krum looks for identifiable markers — a spotless record of compliance with regulatory agencies, a star manager or cohesive team, and incentives tied to firm ownership and fund performance.

"We want to see a decision-making process that is crisp and fast-moving," Krum said.

But make sure a promising firm isn't gathering assets too quickly, adds Jim Peterson, a vice president at the Schwab Center for Financial Research. Rapid growth may overwhelm a lone manager or sharp-shooting firm, he said, and investing can take a back seat to marketing.

"Institutions look at people, process and investment philosophy," Peterson said. "Things you think about are, where did performance come from and what is it about their process that makes it likely they'll repeat?"

To find small-manager standouts available to individual shareholders, investment researcher Morningstar searched firms with mutual-fund assets of $2 billion or less that boasted stock offerings in the top 25% of their peers over the past five years.

Hodges is a good example of a strong small shop with a single fund, according to Morningstar. So is Auxier Asset Management, which runs the Auxier Focus Fund (AUXFX) , and Al Frank Asset Management, manager of the Al Frank Fund (VALUX) .

Among families with more than one offering, Berwyn stood out on the strength of its Berwyn Fund (BERWX) and sibling Berwyn Income Fund (BERIX) .

Other noteworthy multifund firms in the fund screen included Saturna Capital. The firm has about $950 million in assets, mostly in the Amana Trust Growth Fund (AMAGX) and the Amana Trust Income Fund (AMANX) , two large-cap stock funds that follow Islamic prohibitions on investments in areas such as gambling, tobacco, alcohol and banks.

Saturna also manages the nonfaith-based Sextant fund family, including Sextant International Fund (SSIFX) .

Being too small carries risks

Saturna founder Nicholas Kaiser, said one key to a small firm's appeal is alignment with shareholders' interests and more personalized service. Indeed, dialing some small funds directly gets the manager on the line.

"The small adviser is focused on that business," Kaiser explains. "They can take a much longer outlook."

That said, Kaiser echoes a finding in the Northern Trust research that investing with a mom-and-pop fund shop carries the risk that poor results will torpedo its business.

"Most small firms probably do best if they have several strategies, because time does weed out poor strategies," Kaiser said.

"A small adviser is just like an investor," he adds "The more diversified he is, the more stable that firm can be."

Copyright (c) 2007 MarketWatch, Inc.