Our second mock portfolio selection: Small Cap Value mutual fund

I suppose it seems hard to understand why we would even bring up these types of mutual funds. After all, weren't these the kinds of funds that investors lost their shirts on in the last couple of years? Well, no and yes, to the extent that people loaded up on one sector, forgetting the seesaw rule (diversification).

Other investors lost value even though they thought they were diversified, only to find out that certain fund managers, in true style drift, stacked the deck by purchasing shares of high-flying tech stocks, rather than sticking to the investment objective statement the fund was originally set up for.

What does this investment objective mean in context of the fund itself; simply put, if the mutual fund is launched with aim of investing in large cap growth stocks, then at least 75-80 percent of the stocks in the portfolio are supposed to fall within that criteria.

What has happened in the past, is as large cap growth stocks fell out of favour - and down in value - some fund managers bought almost anything, it seemed to bring the total return of the fund up. In other words, your large cap funds started resembling twins of small cap products. Some investors found out that they had two to three hundred percent more exposure to risky sectors than their portfolio indicated.

Janus Funds took a lot of fire on this tactic, but they were not the only Fund Companies by any means. Yes, there were a lot of unhappy people at the end of last year. However, in the midst of the downturn, some small cap funds outpaced their larger-cap rivals through 2000-2001.

Small cap value funds did very well, with the leader among them, returning 47.5 percent. In general, small cap funds tend to carry more risk than their larger cap cousins, but small cap value funds may have long-term risk/reward profiles and make good diversifiers to core holdings.

They also are not correlated with the S&P 500 index more than about third of the time, whereas the average large-blend fund returns are 90 percent correlated. Being positively or negatively correlated indicates that the fund will perform somewhat opposite to index. Again in the seesaw concept, if the S&P index is down, the small cap value fund may just sailing merrily along. And that is precisely what happened last year.

One of the strategies of fund managers when picking small cap value stocks is to focus on really cheap stocks with strong fundamentals and catalysts for improvement. What does that mean to the layman? First, it means that the company has a capitalisation of one billion dollars or less; it also means that the company is making real profits, not like so many of the tech stocks that never turned a profit. Hard to believe that even at this date, amazon.com - as much as it has grown - has yet to turn a profit! What will happen when they can't borrow any more money?

The reputation of good small cap mutual funds travels quickly. Most of the highly rated ones last year have already closed their doors. Some have self-imposed mandates at inception of the fund which may state that when it reaches critical mass - say $1 billion - they will cease taking new investors.

This decision does not seem to make sense when one realises that the Fidelity Magellan Fund boasts about $75 billion - yes, that's billion - in investor assets. Small cap fund managers must keep the funds small, else how can they move quickly in buying and selling the smallest publicly and thinly traded companies in the market. Imagine, if you will trying to buy 200 million shares of a small company stock for the Magellan Fund; 200 million may be the entire share offering on the open market for a small company!

Small cap fund managers need to be able to manage a smaller asset pool of diversified small companies, as well. If the fund grows too large, they are forced to buy more readily available shares in larger companies, and then in the ultimate catch 22 - are no longer small cap companies!

Let's review our fund choice:

Investment Objective This fund normally invests at least 65 percent of its assets in equity securities with market caps not exceeding 500Million - these are small companies. It may invest up to 35 percent in larger companies. It may also invest up to 25 percent of its assets in ADRs and EDRs, and a big and, it may also invest in derivatives, repurchase agreements, futures and options. These concepts and hedging type investment vehicles will be discussed in future articles. That is their statement of intent so to speak and they are supposed to operate by this mandate.

Note: that as we gradually bring this portfolio together, we will cover all of these acronyms, such as ADRs in some depth. Not enough space.

Performance chart: Looking at the performance chart, you can see that this fund has consistently outperformed the index and its peer group, for all three years of operation; not a very long track record, but certainly a good start. Statistically, if true diversification theory is to be believed, as growth stocks come back into favour, the returns of this fund may slip to single numbers. Nothing wrong with that! In the diversification process, it did its job holding up portfolios when other funds slipped badly. Is it a keeper? Yes, but unfortunately, in reality this fund is closed to new investors. Success has its own punishment.

Other criteria - These are all evaluation criteria that will distinguish this fund from its competitors and help you with the decision on which to ultimately purchase.

Expense ratio - more expensive than other funds, numbers not available but projections are.

Turnover (the number of times expressed in percentage that assets are bought and sold in one year) number not available.

Risk Rating is low compared to other funds in the same peer group. This means your invested money is taking the least risk to earn the same return, whereas another fund with an equal return may be extremely risky and volatile.

Ranking There are over two hundred funds in the value category, yet it has had very consistent upper tier performance.

Two new criteria introduced this week:

Consistency of Fund Management - The Lead Manager has been with the fund since inception, a good sign. We don't want the Manager of the month running our fund picks. Who knows what they will do to make a reputation.

Net Asset Size - yes, it is a small fund. Note that last week, I stated anything below critical mass of 80 million for a fund was tough going. This fund actually hit the $1 billion mark in less than two weeks at the end of the year 2001; in the last two days of December, investors chasing it frantically poured in $20 million!

Sector Weightings This is an important criterion. As a financial planner and investment advisor, I want to have some comfortability that this fund is diversified across industry sectors, with not too big a concentration in any one, and it is, although reading between the lines, they love either banks, insurance companies/finance companies and brokerage financial institutions. They must think we are all going to make big money this year, when interest rates bounce back. We will see.

Martha Harris Myron CPA CFP is a Certified Financial Planner (TM) (US) practitioner. She holds a NASD Series 7 license, is a US tax practitioner, and is the winner 2001 - The Bermudian Magazine - Best of Bermuda Gold Award for Investment Advice. Confidential E-mail can be directed to marthamyronnorthrock.bm. The article expresses the opinion of the author alone.Under no circumstances is this advice to be taken as recommendations to buy or sell investment products or as a promotion for financial plans. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.