Money Flows Into Small-Cap Mutual Funds as Sector Rallies

Reversing a months-long trend, investors have begun to return to small-stock funds, mutual fund companies report.

The shift comes four weeks after small-capitalization stocks, which have mostly lagged larger-company stocks for more than three years, began an explosive rally, with the benchmark Russell 2,000 index of small companies advancing 25% in just the last 18 trading days.

It also hints at the possibility that the so-called “January effect”--a phenomenon in which small caps tend to rally during the first month of each year--may be taking place much earlier.

“This is a very positive sign,” said Laura Allen, manager of the John Hancock Special Equities fund, a small-cap portfolio that began receiving net cash inflows in the last couple of weeks following months of outflows.

However, Carl Wittnebert, director of research for the Santa Rosa, Calif., research firm Trimtabs.com, cautioned, “This isn’t exactly a flood of money.” Still, he noted that in the two weeks through last Thursday, $90 million flowed into the 14 small-cap funds tracked by his firm.

On a percentage basis, that’s more money than has flowed into these funds in any month this year--and more in dollar terms than in any month since April, when small stocks overall peaked.

“We haven’t seen this kind of consistent flow in a while,” said Wittnebert, noting that $16 million more flowed into these funds on Friday and Monday.

Trimtabs also measures small-cap fund flows by tracking the “aggressive growth” category of stock mutual funds, which tends to overlap with small caps. Trimtabs believes that a net $1.4 billion flowed into these funds in October, with a net $1.1 billion of that coming in the final week.

The trends are more subtle among 401(k) investors. But they’re there.

Cigna Retirement & Investment Services in Hartford, Conn., the nation’s third-largest 401(k) plan sponsor, reports very few exchanges into stock funds in recent weeks. Yet, among 401(k) participants who earn $100,000 a year or more, there has been some movement toward small- and mid-cap funds, said Cigna Senior Vice President David Castellani.

What’s driving these investors?

Financial planner Ron Roge of Bohemia, N.Y., noted that small-cap funds have received increasing publicity recently.

Much of that press has described those funds as woefully undervalued and reminded investors that small caps are due for a rally, after falling nearly 40%, on average, from April to early October.

Roge, for instance, noted that prior to the recent market slide, the Russell 2,000 index has fallen 20% or more four times going back to 1980. In the months following each of those small-cap bear markets, these stocks went on to gain at least 70%.

But Gerald Perritt, editor of the Mutual Fund Letter in Largo, Fla., said the reason is probably more simple than that.

He noted that the Russell index bottomed on Oct. 8. Cash flows, he said, have followed the improving returns. “Individual investors are always about a week late.”

In addition, small-cap funds, whose fiscal years usually end on Oct. 31, are done with their tax-loss selling. Managers often decide to sell losing stocks to offset capital gains at the end of the fiscal year, particularly if they want those stocks out of the portfolio anyway.

As that selling subsides, small stocks may find it easier to rally.

John Hancock’s Allen agrees with that logic, but she noted that small caps may be due for a short pullback, as individual investors begin their own tax-loss selling.

Once that’s over, she said, she thinks small caps are due for a sustained rally.

But Satya Pradhuman, small-cap analyst for Merrill Lynch in New York, remains cautious.

“This rally could be a head fake,” he said. And these mutual fund flows could be chasing a short-term blip.