Hot microcap funds could burn investors

Your Money

October 30, 2005|By LEON LAZAROFF | LEON LAZAROFF,CHICAGO TRIBUNE

NEW YORK -- When Tom Barry launched a microcap mutual fund back in 1997 in the midst of the Internet boom, the financial community yawned: Who, after all, would want to invest in the stock market's tiniest companies when large-cap stocks were doing so well?

But Barry, chief investment officer of the $1.3 billion Bjurman, Barry & Associates hedge fund in Los Angeles, saw microcap companies - widely defined as stocks with a market capitalization between $30 million and $300 million - as undiscovered gems.

With comparatively few shares publicly traded and little to no information available outside of a company's financial statements, these stocks were inherently volatile, susceptible to wide swings, both up and down.

Barry saw those attributes as reasons to jump in.

"For me, fewer analysts covering these stocks meant opportunity," said Barry, who directly manages the $530 million Bjurman, Barry Micro-Cap Growth Fund. "Low liquidity meant the larger funds would stay away, giving us a chance to identify good companies early on."

When the tech bubble burst in 2000, that same financial community took notice of the 43.5 percent gain that Barry's microcap fund produced for that year.

In today's mostly sideways market, many investors restless to find high-performing companies are closely eyeing microcap stocks in hope they'll extend the run that small-cap stocks have enjoyed in recent years.

But the qualities that make microcap stocks attractive also make them risky.

Low liquidity - that is, relatively few shares for sale at any one time - means a fund manager could have trouble buying a company's stock when its price is rising, or selling it if shares were to suddenly fall.

Financial analysis on microcaps is not easily available. Because microcaps have low liquidity, Wall Street firms and their analysts focus almost exclusively on larger companies. Those interested in individual microcap names are frequently on their own.

That's why even the most risk-tolerant investors should keep microcaps as a small fraction of their portfolio, experts said.

Nonetheless, microcap stocks in recent years have performed far better than the market's largest and best-known companies.

From 2000 through September, microcap stocks produced an annualized average return of 13.1 percent. That's sharply higher than the Standard & Poor's 500, the market's largest companies, which fell an average of 1.5 percent, according to a study by Ibbotson Associates Inc., a Chicago financial consultant group.

And this trend isn't confined to recent years. From the beginning of 1926 to the end of 2004, microcap stocks produced an annualized return of 12.7 percent, compared with 10.4 percent for the S&P 500, according to Ibbotson.

The Ibbotson study looked at the smallest 4 percent of stocks based on market capitalization. In 2004, the average microcap stock in the study had a market cap of $419 million.

With prospects of such high returns, it's little wonder that three exchange-traded funds specializing in microcap stocks have emerged since August:

The Dow Jones Select MicroCap Index Fund is managed by First Trust Advisors.

PowerShares Capital Management handles the Zacks MicroCap Portfolio.

Exchange-traded funds heavyweight Barclays Global Fund Advisors manages the iShares Russell Microcap Index.

Unlike mutual funds, exchange-traded funds are sold like any other stock. For that reason, investors can easily gain exposure to a portion of the market they might not understand, and therefore would be likely to avoid.

When hearing the word "microcap," Dan Waldron of First Trust Portfolios of Lisle, Ill., said investors often think of penny stocks or "pink sheet" stocks, marginal equities that have been known to cause financial ruin. "We do sometimes have to explain that microcap simply means a small company," he said.

It's important to realize that exchange- traded funds differ from many mutual funds because the latter are actively managed whereas ETFs select stocks for their indexes based on strict statistical criteria.

The Zacks and Dow Jones indexes use valuation criteria such as price-to-earnings and price-to-sales ratios to eliminate poorer-performing stocks. Along with liquidity, momentum is another important benchmark.

"We don't incorporate the emotional," said David Cohen, managing director of index strategies at Zacks Investment Research. "We identify certain characteristics and don't deviate from them."

The iShares Russell fund is largely based on capitalization.

Reflecting their particular investment strategies, the three funds are also differently structured.

While the iShares Russell fund includes some 2,000 names, the PowerShares fund holds 399 stocks, and the Dow Jones fund has 309.

The Bjurman-Barry fund, by comparison, keeps just 120 stocks in its portfolio, preferring a more aggressive strategy of making larger bets on fewer names.

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