Time to Jump Into Rebounding Small Caps? You May Want to Wait

Finally, a light at the end of the tunnel. Or so it seems.

Since the end of August, small-company stocks have actually been beating their large-cap cousins, the drivers of the recent bull market.

Granted, the rally is just 4 weeks old.

But given the fact that small caps have disappointed investors going on five years now--and considering how cheaply the shares of small-cap portfolios now trade (remember, the sector fell into an official bear market on Aug. 25)--bargain-hungry investors are likely to wonder: Is this the time, finally, to move back into small-company mutual funds?

Maybe not quite yet.

As appetizing as small-cap stocks may seem right now (the benchmark Russell 2,000 index of small-cap stocks has advanced 9.3% since the end of August, versus just 6.6% for the Dow Jones industrials), there are several reasons investors may want to hold off on plowing more money into a small-cap portfolio. At least for another month or so.

For starters, now that we’re entering the final quarter of the year, thoughts naturally turn to taxes.

Some managers, like Robert Kern of the Fremont U.S. Microcap fund, have already used the recent market correction to lock in losses in their portfolios. In other words, they sold off losing stocks to offset capital gains built up in other parts of their portfolios, thus lowering the fund’s overall tax bill (which eventually gets sent to investors).

However, others aren’t done doing so.

Since most mutual funds run on a fiscal year that ends Oct. 31, this “tax-loss selling” should last through mid-October. Laura Allen, who leads the John Hancock Special Equities fund and John Hancock Emerging Growth, notes that there might still be a decent amount of selling left because August was the second-worst month for small-cap stocks on record.

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All this selling will tug at stocks somewhat unpredictably. “You’re likely to see heightened volatility [in small-cap stocks] over the next few weeks,” Allen said.

This volatility is likely to be exacerbated should fund investors continue to redeem money from small-cap portfolios, argues Schroder & Co. emerging-growth strategist Dan Coker.

Why? If fund managers are forced to sell long-held stocks to meet redemptions, they’ll look to offset any gains created by the forced sales, Coker notes.

What are the chances of further redemptions? Fairly good.

Remember, like mutual fund managers, individual investors themselves are beginning to sell some of their losing investments to offset gains in their portfolios. (If they haven’t already, they should.)

Since small-cap funds lost 22.2% from the end of the second quarter through Sept. 17, what better non-core holding to chuck than an under-performing small-cap fund? Such thinking could dampen the performance of small-cap stocks heading into the fourth quarter, analysts say.

There’s one more reason to wait.

As experienced fund investors know, this is the time of year when fund managers distribute long-term capital gains that have built up in their portfolios.

For those who don’t know how this works, imagine you invest $10,000 in a fund with a net asset value per share of $20. You would own 500 shares. Now imagine that the fund distributes $2 per share to its investors. The distribution reduces the fund’s NAV to $18 per share.

Whether you take the distribution or reinvest it (which would get you about 56 more shares), you’re still liable for taxes on that $1,000 distribution.

Had you waited to buy into the fund after the distributions were made, you would have simply received 556 shares of the fund at an NAV per share of $18.

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None of this may seem relevant to you, because the typical small-cap fund has lost 20.8% of its value since the beginning of the year through Sept. 17, and is down 19% over the last 12 months. What kind of gains could they have?

But Salomon Smith Barney small-cap analyst L. Keith Mullins offers this warning: “Despite these losses, most funds have booked gains on individual issues during the year. As such, a taxable distribution to investors could occur for funds that have actually lost money for the year.”

And it could occur earlier than usual.

Consider the Oakmark Small-Cap fund, which recently reopened to new investors. This $1.2-billion fund has lost 26.1% so far this year and is down 25.7% over the last 12 months. Yet in August, it distributed long-term gains of $2.02 per share to its investors.

Why did the fund company do this now rather than wait until the end of the year? Company officials say they wanted to reduce the likelihood of a larger-than-expected distribution at year’s end. Also, they wanted to clear the decks to make the fund attractive to new investments later in the year--because many investors are concerned about getting slapped with a tax bill.

So what should you do?

If you have a wish list of dirt-cheap small-cap funds, think about waiting at least until the end of October.

If you don’t want to wait--and you’re willing to live through another wave of small-cap under-performance for the next month or so--at the very least call the fund companies and ask them if the portfolio you are interested in has already distributed capital gains.

If the fund hasn’t done so yet, ask if a distribution is expected. If so, ask when it’s scheduled.

The last thing you want to do is buy into an under-performing fund that’s about to present you with a tax bill for activity that took place before you were even invested.

Notes Kern of the Fremont fund: “That’s adding insult to injury.”

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Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.