Another aspect of good fund management is finding a winning strategy and sticking with it. That sounds simple, but many funds have a lot of trouble sticking to a core approach.
Perhaps the most common reason funds stray from a winning strategy is that their own success makes it difficult to keep doing the same thing. A value fund may find itself tempted to buy promising growth stocks, especially when value stocks aren't doing well. Domestic funds may want to buy international stocks, and vice versa. But where you see this phenomenon most commonly is with small-cap funds owning shares of larger companies.
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, asset levels will increase -- and a unique problem arises.
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'd 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.
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.
And remember, this isn't just something to pay attention to in small-cap funds. Any fund can move away from its target sector of the market, and if it does, you should keep your eyes open. It may no longer serve the purpose you want it to have for your portfolio.
Still with us? We wrap up our approach in our final article.