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Small-Cap Growth Funds: A Surfeit of Riches: Mutual Fund Focus, October 2009

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News and analysis from Standard & Poor’s MarketScope Advisor

Love ‘em or hate ‘em, there’s no denying that small-cap stocks have been heading northward like a herd of buffalos in the springtime, galloping to a thunderous 79% gain from the stock market low in March to mid-October. Like a herd of buffalos, there are so many of them, it’s impossible to pick which one will lead the pack.

For this reason, small-cap stocks seem tailor-made for mutual funds, which offer the diversification and professional management that are essential for success and that an individual investor would find hard to replicate. There are hundreds of mutual funds that invest in small cap stocks–loosely defined as having a market capitalization of less than $3 billion–so finding the right fund takes a bit of digging.

Dividing the small-cap universe into growth and value styles narrows the range of options somewhat. For the year to date through October 9, small-cap growth stocks, as measured by the S&P SmallCap 600 Growth index, outperformed small-cap value stocks handily, with the growth index rising 23.2% compared to a 17.5% gain for the value side.

Even sticking with small-cap growth funds, however, there are well over 100 funds to choose from.

To thin the list, we omitted all funds that are not accepting new shareholders and funds with assets of less than $20 million. From that group of roughly 100 funds, just seven carry Standard & Poor’s highest 5-Star rank, and of those seven, four stood out as particularly attractive. Two funds,Vanguard Small-Cap Growth Index (VISGX) and Wasatch Small Cap Growth (WAAEX), also ranked in the top 10 of small-cap growth funds in terms of assets under management, an important indicator of investor confidence and long-term success. Two other 5-Star funds–Janus Triton (JATTX) and TCW Small Cap Growth (TGSNX)–posted the best three-year returns of the entire group, indicating they performed well through a wide variety of market conditions.

Of these funds, only one, Vanguard Small-Cap Growth Index, is not actively managed. The Vanguard fund is passively managed to track the MSCI U.S. Small Cap Growth index, and carries a low expense ratio of just 0.28%. Its large size, $4.8 billion in assets as of August 31, allows it to hold almost 1,000 different stocks, about as much diversification as anyone could ask for. Its largest holding is biopharmaceutical company Human Genome Sciences (HGSI), which makes drugs to treat hepatitis and cancer, but accounts for less than 1% of the fund’s assets.

Wasatch Small Cap Growth is much smaller, with about $820 million in assets. It is actively managed and therefore has a higher expense ratio than Vanguard’s fund–1.2%–but that is still low compared with the 1.6% that most small-cap stock funds charge. The largest of Wasatch’s 86 holdings as of June 30 was MSCI (MXB), a New York-based index publisher and provider of investment decision support tools; it accounted for about 3% of the fund’s assets.

Janus Triton and TCW Small Cap Growth topped the list of funds for performance over the past three years, two of just a handful of funds that have a positive annual return over that period. Of the two, the Janus fund is larger, with $343 million in assets versus $187 million in the TCW fund. The Janus fund held 82 different stocks as of Aug. 31, with MSCI the top holding at 2.5% of the fund’s assets. The TCW fund owned 70 stocks, led by Mercadolibre (MELI), the “eBay of Latin America,” which accounts for 2.7% of the fund’s assets. Janus charges an expense ratio of about 1.2%, compared with 1.6% for the TCW fund.