Threshold for 'Small' Firms May Be Too High

Russ Wiles is a mutual fund columnist for The Times and co-author of "How Mutual Funds Work."

If you think your small-stock mutual fund invests in small companies, you might be in for a surprise. The typical fund really looks and behaves more like a mid-cap portfolio, according to a recent study.

Small companies commonly are defined as firms whose combined shares are worth less than $1 billion. Yet that threshold, which has been popularized through the efforts of fund researcher Morningstar Inc. of Chicago, is too high, says Scott Leonard of Leonard Capital Management in Santa Monica. That's because about 80% of all issues on the New York and American stock exchanges and Nasdaq fall below the $1-billion range.

A more realistic measure would define small companies as those with market values, or "capitalizations," of about $160 million or less, he says. Why that figure? It's roughly the median size of the smallest 20% of companies on the New York Stock Exchange.

The vast majority of mutual funds don't buy stocks this small. Leonard recently examined 3,661 domestic funds in Morningstar's database and found only 1% owned stocks that, on balance, have a median capitalization of $160 million or less. Even small-company funds usually troll for bigger fish.

Leonard believes proper classifications are critical for investors anticipating the higher returns and diversification benefits typically associated with small companies.

"If you are buying small-stock stocks [or funds] for the above reasons, smaller is better," he said.

One tip Leonard suggested: Seek out funds that bill themselves as "micro-cap" portfolios.

Manager Ethics

Another recent study suggests that investors may want to consider the ethical standards of funds in which they invest.

Researchers at, a financial Web site, polled more than 30 large fund groups on five ethical matters. No firms scored anywhere near a perfect grade.

Fund companies that link management fees to portfolio performance received good marks. They also gained points for willingness to close large portfolios to new investors, under the theory that too much asset growth can erode returns for existing shareholders.

Fund families received poor marks if they make use of 12b-1 marketing fees. They were also penalized for utilizing "soft dollars" to pay for daily expenses, from quote machines to stock research. What essentially happens is that many fund companies do business with brokerages that provide certain goods and services, even though they're supposed to obtain the lowest commissions on behalf of shareholders. Another problem with soft-dollar expenses is that they often are not disclosed.

The final issue examined was whether portfolio managers should be allowed to trade stocks in their own accounts. This counted heavily in the rankings.

"Most firms have extremely strict [conflict-of-interest] rules that severely restrict short-term trading," Executive Editor Jamie Heller wrote in the study. "But even assuming a world free of conflicts, if you're running money for your shareholders and for yourself, you're more distracted than you should be."

Janus Funds of Denver was the only large group to prohibit personal trading. "We took that position to ensure our managers do what's right for shareholders and really focus on their funds," said Lorrie Grove, a company spokeswoman.

Janus' fund managers have free rein to buy whatever mutual funds they want, but stocks are off-limits, Grove said. The firm's policy has been mandatory since 1996.

Janus tied with Fidelity and Vanguard for first place in the survey, each with six points of a possible 11.

Six firms--Alliance, Delaware, Evergreen, Invesco, Smith Barney and Waddell & Reed--tied for last, with no points. Five other firms--Davis, Dean Witter, Dreyfus, Prudential and Seligman--did not participate.

Annuities Look Good

Variable annuities are proving tough competition for mutual funds, according to a new study by Lipper Analytical. During the first quarter, annuities that invest in the stock market rose 12.51% on average, compared with an average gain of 11.91% for equity mutual funds. In addition, annuities won out in 16 of 19 stock investment categories.

Longer-term results also bolster the case for investing in annuities: The tax-sheltered accounts beat straight mutual funds in 15 of 19 equity categories over five years through March 31.

Despite this, A. Michael Lipper, president of Lipper Analytical, downplays the results.

"The universes are not comparable enough for scientific measurement," he said. "Annuities have different mixes of managers and cash flows compared to mutual funds."

Those results don't include the insurance costs that are part of a variable-annuity investment. These are "mortality and expense" fees, usually ensuring a minimum value if the investor dies or providing some other insurance-like guarantee. They add more than 1% a year to the typical annuity cost.


Russ Wiles is a mutual fund columnist for The Times and co-author of "How Mutual Funds Work." He can be reached at

Copyright © 2019, Los Angeles Times
EDITION: California | U.S. & World