Good Things Come in Small Packages

If you're looking for obscure, underappreciated companies, you'll find plenty of them in the micro-cap stock universe.

Micro-caps generally include companies with market capitalizations up to $300 million. The fact that many investors ignore companies this small means there are often hidden gems to be found buried among these tiny stocks.

A look at two funds that focus on micro-cap stocks -- Royce Micro-Cap (RYOTX) and Bridgeway Ultra-Small Company Market (BRSIX) -- reveals interesting twists on the varied ways funds search for undiscovered stocks. As both of these have been successful, it's clear that micro-cap funds can achieve solid performance in more than one way. Investors willing to take on the high risk and volatility of this sector of the market can see significant rewards for their efforts.

Fund

Minimum Investment

Inception Date

Expense Ratio

Net Assets

Bridgeway Ultra-Small (FUND:BRSIX)

$2,000

7/31/1997

0.67%

$844 million

Royce Micro-Cap (FUND:RYOTX)

$2,000

12/31/1991

1.46%

$857 million

Source: Morningstar.

Fund specifics
Royce and Bridgeway are both micro-cap funds with portfolios of similar sizes. The funds differ markedly with their investment approach, however; one is actively managed and the other is an index fund. Normally, comparing a passively managed index fund and an actively managed fund would be like comparing apples and oranges. But because these two are performance leaders, a look at what makes them tick can help determine which one best suits a particular investor.

Royce invests primarily in companies with market caps below $500 million and is managed by a team of three portfolio managers. The fund has more than 200 holdings with an average market cap of about $290 million. The fund's top three holdings are Olympic Steel (Nasdaq: ZEUS  ) , Bruker BioSciences (Nasdaq: BRKR  ) , and science and engineering consulting firm Exponent.

In contrast, Bridgeway tracks an index developed by the University of Chicago's Center for Research in Security Prices. The fund selects a representative sample from CRSP's Small Cap-Based Portfolio 10 Index.

With 484 securities, Bridgeway has more than twice as many holdings as Royce. In addition, Bridgeway has a lower median market cap of $193 million. Bridgeway uses small-cap exchange-traded funds (ETFs), such as iShares Russell 2000 Value (NYSE: IWN  ) and iShares Russell 2000 Index (NYSE: IWM  ) , to give the fund low-cost exposure to small-cap stocks. But the fund also includes individual stocks, such as home health-care provider Amedisys (Nasdaq: AMED  ) .

Both funds have provided strong performance in recent years. Royce has a 10-year average return of 11.4%, and Bridgeway comes in just a bit higher at 11.5%. Those returns are more than twice the Russell 2000 small-cap index, showing the value of having some exposure to the tiniest companies available to everyday investors.

Portfolio fit?
Micro-cap stocks have their own special risks. Some of these companies only have a small amount of shares that are publicly traded, and as a result their share prices may be manipulated easily. Micro-cap stocks are among the riskiest of investments, so many investors may want to stick with somewhat larger companies for their small-cap exposure.

For investors who choose to participate in this part of the market, micro-caps should generally comprise only a small portion of their overall investment portfolio. Investors who do take on the risk of micro-cap securities, however, may benefit from the diversification they provide and earn rewarding returns.

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8/29/2014 3:59 PM
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