Any truly diversified mutual fund investor needs at least some exposure to small-cap stocks. Think of small-caps as the orange juice of your portfolio -- a bit too acidic on their own, but a part of a complete, balanced breakfast.
But small-cap managers face special challenges that their larger-cap counterparts don't. And if you don't watch out for some of the warning signs, you could be unpleasantly surprised by what your small-cap fund is doing.
An inconvenient truth
Small-cap managers often face a harsh reality: The greater their fund's success, the harder it is to maintain. Any manager, small-cap or otherwise, who posts a consistently positive track record will soon draw the attention of investors seeking higher returns. Money will pour into the fund, increasing asset levels -- and creating a unique problem.
Since these managers are focusing on stocks with relatively small market capitalizations, too much money can actually be a bad thing. For example, if the fund reaches $10 billion in assets, managers must buy a 10% stake in a $1 billion company to give that company even a 1% representation in their funds. And it's extremely difficult to get into and out of a 10% position of any company's shares without moving the market.
That's why so many small-cap funds close their door to new business. If a fund company is truly shareholder-friendly, it will close the fund before asset bloat becomes an issue. But how do you know when assets are starting to reach unmanageable levels? Well, besides keeping a close eye on the fund's net asset levels, you can watch out for several factors.
Stuffed with cash
You'll find one hint that a small-cap fund is reaching its limit in the amount of cash the fund has on hand. While some funds tend to hold more cash as a byproduct of their investment process, a small-cap fund that suddenly finds itself sitting on a lot of cash may be running out of places to invest. If you find that your fund's cash reserves have been increasing along with net assets, it's quite possible that management isn't finding enough attractive small-cap opportunities.
It's never a good thing when a fund holds a significant portion of its assets in cash. You're paying fund managers to invest your money in the stock market, not to have it sitting on the sidelines. If you wanted to do that, you would be invested in a money market fund.
You should also pay attention to the holdings within the fund. Does your fund still consist of mostly small-cap stocks, or is it drifting into mid- and large-cap territory? You shouldn't penalize your manager for owning a few larger companies, but you should make sure that the bulk of fund assets are invested in legitimately small stocks.
One closed small-cap fund that I happen to like is Champion Funds selection Royce Premier
While Premier has continued to perform admirably, the fund cannot help but push into larger stocks as its asset base grows. This is a great fund, but its ability to continue to invest nimbly in small stocks will likely be compromised at some point in the near future, if asset levels keep rising.
Capping it off
In addition, keep your eye on your small-cap fund's average market capitalization. As a general rule, you want to see an average market cap of roughly $2.5 billion or less. Any more than this, and you're probably getting mostly mid-cap exposure. There is, of course, some leeway with this rule of thumb, depending on the manager's investment process, but if you buy a fund for small-cap exposure, that's what you should be getting.
Small-cap investing is important, so don't skimp on it, just as you shouldn't skimp on your morning breakfast. Knowing some of the warning signs can give you a heads-up that your small-cap fund may be struggling under its own weight. Stay alert, and you'll stay one step ahead of the market.
Whether you're looking for small-cap funds, large-cap funds, or international stock funds, find out which mutual funds have the best chance of beating the market. Check out the Fool's Champion Funds newsletter with your free 30-day trial today.
Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy takes its morning coffee with two sugars and no cream.