Micro Caps Down But Not Out

May 21, 2008

For patient investors, the smallest of the small-cap universe still offers diversification and long-term potential at beaten-down prices.


It was just five years ago that micro-cap stocks were soaring to new heights. But now, as big blue chip companies return to favor, the tiniest of the small-cap universe remain near the bottom of most stock fund categories.

That includes a once-high-flying Bridgeway Ultra-Small Company Market Fund (BRSIX). The nearly 11-year-old mutual fund, one of the oldest and most popular index micro-cap portfolios on the market, has lost more than 8% so far this year.

To put that into perspective, the exchange-traded fund iShares Russell 2000 Index (NYSE Arca: IWM) is down 2.7% in 2008. (It's also considered a small-cap blend fund, although the $9.1 billion IWM has a market cap roughly three-times BRSIX's size.)

The Bridgeway fund isn't alone. Three ETFs that also follow micro-cap benchmarks are also badly underperforming their small-cap peers. Those are: iShares Russell Microcap Index (NYSE: IWC); First Trust Dow Jones Select MicroCap ETF (AMEX: FDM); and PowerShares Zacks Micro Cap ETF (AMEX: PZI). (See chart below.)

Still, micro caps remain a favorite with many long-term investors. BRSIX's assets top $862.7 million, not a small sum for a portfolio with a median market cap of $193 million. And BRSIX's almost double the size now as it was when Bridgeway had to close the fund for two years starting in 2003.

A Time Of Change

In 2004, micro-caps were still in the spotlight. BRSIX sat at the top of the heap with a three-year average annualized return of better-than 32%. That came on the back of a 24% gain in 2001 and 4.9% in 2002.

By the end of 2003, the index fund soared to return 79.4%, marking a stunning run of outperformance through the worst of the tech wreck and the subsequent surging bull market.

As cycles have cooled, BRSIX has slowed even more dramatically. In 2004, it fell to a middling performer. And after back-to-back years in the top 2% of its small-cap class, the micro-cap portfolio faded in less than a year to fall into the bottom 20-30% in subsequent years, according to Morningstar data.

Such a turnaround shouldn't be all that surprising, though. In strong small-cap-dominated cycles, it's not unusual for the smallest of the small to shoot up more than their larger rivals. When conditions weaken, micro-caps tend to underperform. And sometimes by large amounts.

So why even bother with such a volatile part of the market? Over longer periods, the category has proved to be an even higher flyer than regular small-caps. Just look at BRSIX. Over the past 10 years, despite its extreme highs and extreme lows, the fund's average annualized total return of 11.44% beats the broader market by a mile. For example, the Vanguard Total Stock Market Index Fund (VTSMX) is up an average 4.29% in that same period.

Perhaps even more telling, the Vanguard Small-Cap Index Fund (NAESX) has gained 6.21% in the past decade. That's almost half as much as BRISX's yearly average, even with about 10% of its portfolio invested in micro-cap stocks.

To be fair, NAESX has one of its category's highest market caps at around $1.4 billion. Stacked against a broader Morningstar small-cap benchmark, BRSIX's 10-year return is slightly more than 2 percentage points per year. But that index's performance doesn't count fees and other expenses.

Either way, patient investors with iron stomachs can expect to realize at least some enhanced performance results over time.

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