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Growth, Value or Blend: Small-Caps are Risky Bets Now - Mutual Fund Commentary

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Small-cap funds generally invest in companies having market cap lower than $2 billion. The companies, smaller in size, offer growth potential and their market capitalization may increase subsequently. Small-cap funds are believed to have higher growth potential. Small-cap funds are a good choice for investors seeking diversification across different sectors and companies. Investors with a high risk appetite should invest in these funds.

Small-caps generally outperform large-cap funds. This is true as small-cap funds offer larger growth potential and large-cap funds are generally long-term investments. However, small caps are always riskier than both large and mid cap funds. Small-cap companies are less stable. Talking of risks, analysts have been waving a caution flag as they believe a market pullback will cause more damage to stocks of small market capitalization.

The complacent market mood amid a rally in large cap has been bothering small caps. Moreover, the major issue lies with the valuation. Many have agreed that the market is expensive on several valuation metrics. The small-caps are more vulnerable to the changes in domestic or macroeconomic issues. Investors also need to be cautious about the fact that smaller companies may find it more difficult to survive in extreme adverse economic situations.

Looking into the three segments - growth, value and blend - none of them have given positive returns year to date or in the last one month. Small cap growth funds have however outperformed the others over the long term.

Growth Funds

When capital appreciation over the long term takes precedence over dividend payouts, growth funds become a natural choice for investors. These funds focus on realizing an appreciable amount of capital growth by investing in stocks of firms whose value is projected to rise over the long term. However, a relatively higher tolerance to risk and the willingness to park funds for the longer term are necessary when investing in these securities. This is because they may experience relatively more fluctuations than other fund classes.

Value Funds

Investors looking for bargain, i.e., stocks at a discount, are mostly interested to invest in value stocks. Value stocks are the ones that pay dividends. Thus, investors not only get to buy securities at a discount, but they get a steady income or yield. Reinvesting the income is ideal for investors who are keen on value investing but are not looking for current income.

Blend Funds

Blend funds are a type of equity mutual funds which holds in its portfolio a mix of value and growth stocks. Blend funds are also known as "hybrid funds". Blend funds aim for value appreciation by capital gains. Blend funds offer an amalgamation of what growth and value funds have to present to investors.

Blend funds offer an alternative option for investors who are looking to diversify investments into growth and value assets. Also, blend funds are hugely diversified because they hold a large number of assets to cover both growth and value options.

Performance

The small-cap growth funds have outperformed value and blend options for the long term, i.e., 3 and 5 years duration. Also, Dow Jones U.S. Small-Cap Growth Index has outperformed the broader benchmarks for all periods mentioned.

However, all the benchmarks are in the red for 1 month and year to date periods. The Dow Jones U.S. Small-Cap Value Index has suffered most of the losses for both 1 month and year-to-date periods. The returns for this index are also the lowest for both 3 and 5-year periods. Performance of core funds was somewhat similar to that of the value funds, suggesting growth funds to be the better option for investment here.

The Roller-Coaster Ride of Small Caps

The small caps have had a volatile run through this year, as is evident looking at the movement of the Russell 2000 (RUT) index.

The index moved up till Jan 22 before losing steam and dropping 4.9% year-to-date by Feb 3. It gathered momentum thereafter to reach a yearly high of 1, 208.65 on Mar 4; a gain of 10.42% since Feb 3.

However, the index lost 9.2% thereafter till May 20. The small-cap index once again regained momentum to gain 8.4% from May 20 to Jul 3. From there, the index dropped 7.1% till Aug 1. The index recovered from Aug 1 to trade 3.4% higher till Sep 9. The index is down 7.5% for this year so far and has lost 8% in one month.

3 Small Cap Funds to Sell Now

Going by the larger section of experts who are less bullish on the small-cap sphere, we will pick 3 small-cap funds from each category that should be dropped from an investor's portfolio. Investors may be looking for better value in other funds. There are also suggestions that small-caps will get sold off significantly once there is a market selloff.

Apart from negative returns year to date, these funds carry either a Zacks Mutual Fund Rank #4 (Sell) or Zacks Mutual Fund Rank #5 (Strong Sell) as we expect the funds to underperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund.

Small-Cap Growth Fund

Wells Fargo Advantage Emerging Growth A (WEMAX) invests most of its assets in small-cap companies. The market cap of these companies fall within the range of those listed in the Russell 2000 Index. A maximum of 25% of assets may be invested in foreign securities through ADRs. Being a gateway fund, it invests its entire assets in Emerging Growth Portfolio.

The fund carries a Zacks Mutual Fund Rank #5 (Strong Sell). It has returned a negative 13.1% so far this year and lost 14.6% in one year. The fund has a max front end sales load of 5.75%, as compared to the category average of 5.46%.

Small-Cap Value Fund

Deutsche Small Cap Value A (KDSAX) invests a lion's share of its assets in small cap domestic companies that are believed to be undervalued. The market values of these companies are same as those listed in Russell 2000 Value Index. A maximum of 20% of its assets may be invested in non-US securities.

The fund carries a Zacks Mutual Fund Rank #5 (Strong Sell). It has returned a negative 8.5% so far this year and lost about 0.1% in one year. The fund has a max front end sales load of 5.75%, as compared to the category average of 5.34%.

Small-Cap Blend Fund

Invesco Small Cap Equity A (SMEAX) seeks capital appreciation over the long run. The fund invests major portion of its assets in small-cap firms, primarily in common stocks. These companies should not have market capitalization, at the time of investment, more than the highest market cap of companies listed in the Russell 2000 Index.

The fund carries a Zacks Mutual Fund Rank #5 (Strong Sell). It has returned a negative 5.2%. However, the fund has a positive 4.2% return in one year. The fund has a max front end sales load of 5.50%, as compared to the category average of 5.23%.

About Zacks Mutual Fund Rank

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Learn more about the Zacks Mutual Fund Rank in our Mutual Fund Center .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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