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Mutual Fund Small Caps: The Better Choice

Mutual Fund Small Caps: The Better Choice

by James Gale

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The author has had over 25 years in mutual fund investing. He favors Small Cap Mutual Funds over Large Cap Mutual Funds. To prove his case, he shows year by year, the average total returns in each of these categories for the years 1999 through 2010. The average total yearly returns were provided by Lipper. Small Cap Value and Blend funds returned 9.0% and 8.1%


The author has had over 25 years in mutual fund investing. He favors Small Cap Mutual Funds over Large Cap Mutual Funds. To prove his case, he shows year by year, the average total returns in each of these categories for the years 1999 through 2010. The average total yearly returns were provided by Lipper. Small Cap Value and Blend funds returned 9.0% and 8.1% respectively and were clearly superior to the abysmal returns for Large Cap Value and Blend funds, 3.5% and 2.5% respectively, even when continued through the 2000 and 2008 recessions. Later, the author illustrates comparisons of outcomes over 25 year periods with various investment returns using a hypothetical initial investment of $5,000 and assuming monthly contributions which add another $5,000 per year. In order to safeguard assets at the onset of recessions, he examines easily accessible online private and governmental monthly reports. By using such reports, investors shouldn't hesitate to move their assets to Money Market Funds. Such action will prevent prevent serious erosion of accumulated assets and improve long term investment returns. He is critical of the very limited choices of funds available in 401k and 403b plans compared to those open to IRA investors. However, investors could be in both types of plans. For individuals comtemplating or are already in IRA plans, the author favors using Morningstar to guide their selections. Monitoring their portfolio with Quicken or its equivalent, investors in IRAs using Morningstar's ranking system, have the opportunity to increase their returns by 3% or more over fund averages. Over time, this difference can greatly enhance total retirement assets.

The author is a former CEO of a metal stamping company. He is married with two children. Education: B.A.Manchester University, England.

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Mutual Fund Small Caps

By James Gale


Copyright © 2013 James Gale
All right reserved.

ISBN: 978-1-4772-9669-1

Chapter One


Business Cycles

Before the year 2000, mutual fund investors from 1984 through 1999, typically enjoyed robust returns on their equity fund investments. Often, they would congratulate themselves as to how astute they were to have accumulated healthy nest eggs.

From the year 2000 and ever since, while there have been some market "up" years, we have had two recessions – the last one considered the worst since the 1930 Great Depression. Overall results have been very disappointing for many investors attempting to save for their retirement. If an investor would stay with equity funds as the market trended downwards he or she would lose the accumulated wealth of maybe four or five or even many more years. It could easily take years to regain the assets which were lost in the recession. . At that point, or even earlier, the market could trend downward again for a prolonged period and the disappointing outcome repeat itself.

Let me make one thing very clear. When our economy is truly on a downswing which is not just a short temporary bump you cannot stay in the usual equity funds and expect to beat the market or at least greatly temper your losses. What do I mean by "the usual equity funds"? Size-wise, they are usually in the upper medium size through the very largest. The very worst stocks are in the so-called cyclical manufacturing companies which rise and fall with the strength of the economy such as machinery. Automobile companies and their suppliers are another such category. There are many services which potential buyers can and do postpone, e.g. a computer technology and service which would replace a less efficient but still usable older one. At the other end of the spectrum are those companies associated with food, even though these may not be completely immune from downturns. People have to eat – but they can eat in rather than eat out. Health is another industry which is very durable but once again not completely immune in certain areas such as elective surgery.

At such a period, one needs to go into a defensive posture. What that means is choosing the right vehicles for that purpose. I attempt to examine some alternatives otherwise the important gains which you made in the "up" years are largely going to be wiped out, or at least, severely damaged.

You might ask why, especially in the 2008 recession, brokerages didn't advise all their clients both big and small to make changes in their portfolio. The answer is that such institutions are riven with conflicts of interest. What if, as assuredly it would, word got out that they were advising their clients to leave the equities market? They would undoubtedly receive a torrent of criticism from those publicly held companies and investors in them whose stocks were already being decimated by the downturn and clearly such advice would only exacerbate that problem for them.

Some economists and investment pundits at various points in the sometimes lengthy bottom parts of business cycles where there is no obvious "up" trend, like to suggest that an economic "double dip" is in the offing whereby the economy will trend downwards again in a significant way with no end in sight. One can only say that, in this country at least, that hasn't happened in past economic cycles

In the international arena, globalization has created additional risks. There had been a lengthy period when investing in funds of foreign companies actually "juiced" returns because the value of the dollar declined relative to other currencies over a lengthy period of time thereby increasing returns to US investors. Now, with the dollar at a higher value relative to many other foreign currencies, investment in overseas companies tends to be less profitable or at a greater risk of actual loss.

Today, economic events in certain European countries such as Greece, Spain and Italy get reflected in US stock markets almost immediately even when the relationship seems very tenuous to the health of most American companies.

Another area increasingly confronting mutual fund investors is the ever rising use of hedge funds by wealthy investors usually requiring a six or seven figure investment. The rules differ from those required by mutual funds. One of the salient features is the "shorting" of stocks. When the earnings or prospects of certain companies are poised to decline and the price of such company's stock is likely to decline or has already done so, a hedge fund will "borrow" such stock in the expectation that it will decline still further. The difference between the price at which X shares are borrowed and the new lowered current price times these share quantities become profit. Such strategies appear to encourage more volatility in the market creating unease and further selling by many other shareholders.

The difficulty of predicting the timing and trajectory of the recovery and equity markets depends on the severity of the downturn and a whole host of political factors both good and bad and not limited to the situation in the USA alone.

Eventually, the stock markets start a recovery and each encouraging sign typically creates buying opportunities for investors. The Government of the day typically offers stimulus plans to promote recovery. For a sitting Administration, the electorate is less focused at the time of elections as to whether the economy is all the way back to where it was prior to the recession than whether it is rising again at a reasonable rate. The official opposition believes its best strategy to get elected is not to help the sitting Administration by agreeing to such measures but actively oppose them in the name of taming deficits etc.

Many investment advisors state that their programs contain, at all times, a combination of equity and safe bonds. Therefore, aren't you (meaning me) simply making a pointless change? I would argue that by concentrating your efforts by maximizing them in the "up" years (without the downward drag of the bond funds) you will come out significantly further ahead. Now of course, if your sights are set on averaging a return on your investment in the range of 3% – 7% a year and you are quite satisfied with that result, you will not need to change your approach. At the low end, the charts I just have to, show the end result of that approach at the end of 25 years with a set input for each year. Why does so much of the advisement industry push this approach? I would argue that by setting the bar pretty low, they can sit back and achieve such numbers with minimum effort and claim victory. Conversely, if they set a significantly higher bar for success and either by their efforts and/ or yours fail to get there, they will be blamed – maybe even initiating a lawsuit.

Since 2000, stock markets have become far more volatile with "up" years seemingly fewer compared to "down" years. Furthermore the "up" years are often shallower than some past years. As a result, it has become more difficult to accumulate positive returns. Some individuals can claim with some justification that the returns on equity funds maybe only slightly better and/or irregular to less than volatile bond funds with far less risk. While that can well be true, the situation changes if you leave equity funds at the onset of recession using the tools I describe in detail and then, go into, say, a Money Market Fund. This way, you can protect the potentially far higher returns you have gained in the "up" years and largely retain them.

While we won't know what will trigger the next or other future recessions until they happen, I believe it is instructive to examine the last two recessions to see what lessons can be learned from them. The first one from the March 2000 representing the beginning of declining lows in the market to sustainable upturns commencing in September 2003 had both similarities and differences to the more recent 2008 and 2009 period. In the latter case, while the official end of the recession was June 2009, here in July 2012, there is still high unemployment and a stock market which lurches day to day from improvements to declines. Investors not only have to observe domestic economic trends but those abroad from Greece, Spain and China.

Nevertheless, it is still possible to examine national data which the US Government and the private sector compile and make decisions based on them. It is never a slam-dunk, and one can keep on learning from mistakes and changing course at times derived from this data. You can be reasonably assured that by doing so you will make better decisions than standing pat. This is especially true when contemplating the probability of major declines in your portfolio.

I will be using the NASDAQ Composite Index throughout this book to check the correlation between the economic indicators and stock market movements because that statistic much more closely correlates with these indicators on a day to day basis with the small and medium funds favored.

Chapter Two


I am indebted to Bernard Baumohl's "The Secrets of Economic Indicators" whose highlights I have digested. It is also very well written and easy to follow. In the Second Edition published in 2007, he reviews chapter by chapter, various indicators of changes to the economy and how they affect the stock and bond markets. The very first page of each chapter includes the Website address for accessing these reports. This information allows every investor to inform him or herself on the contents of these monthly reports so that one is not dependent on pundits who may have a specific agenda which isn't necessarily consonant with yours. He is the first to admit that these Economic Indicators hardly conform to a 1 + 1 = 2 relationship. He recognizes that the causes of recessions stem from different causes which make predictions of future recessions, challenging. Nevertheless, while he discusses about seven or eight sources of information both Government and private he finds some correlate better than others to equity stock market movements and, separately, bond prices.

To test Baumohl's conclusions with regard to the equity markets, I looked at each of these two recessions and the degree to which they correlated with specific Government and private sector reports. He also separates some reports which are the best indicators of economic declines from others which are more attuned to recoveries.

* * *

The 2000-2003 Recession

The ISM report – Manufacturing (The institute created by the institute for supply Management (or ISM). web site: www.ism.ws: A manufacturing survey which obtains its information from 400 member companies representing 20 industries. It focuses on new orders by Purchasing Managers including manufacturing output, hiring, order backlogs, and prices among other features. These are weighted and seasonally adjusted. It derives its ultimate single index figure based on activity changes from the previous month.

A PMI reading of 50 is believed to be consistent with a GDP growth of 2.5% *. An index change to 51 would represent about 0.3% growth if continued for over a year. Conversely a PMI reading of 49 does not indicate negative growth but a growth rate of 2.2%. A PMI reading of 47 would indicate a GDP growth rate of 1.6%.

In the year 2000, the PMI fell below 50 for the first time in August 2000. For that month and the next two months, the average was 49.4. The average for all of 2001 was 43.4. That would indicate a drop in GDP growth from 2.5% (a PMI of 50) to about 1.1%. It has to be admitted that were months in 2002 when the PMI went over 51 (an average of 52.9) from March through June of that year. From July 2002, the Index fell again and averaged 49.2 for 12 months from that month through June 2003.

Note: The current format of ISM's Report on Business has changed from the above illustration. You can look at the most recently published monthly ISM Report on Business and the all-important previous month's Index figure is quickly observable. Scroll down to the base of the chart and a small grey rectangular chart appears. On it there is a line chart which shows trends for the last 3 years. If you wish to look at actual numerics for earlier years, you can enter the word "Archives" where "Search" is indicated and you will find a listing of previous years.

Weekly Claims for Unemployment insurance. www.doleta.gov/unemploy/wkclaims/ report.asp: In the first month or two of each year, temps lose their Christmas jobs and file for unemployment. After that, up and down changes better reflect the health of the economy. Even so, it is better to consider quarterly averages rather than single months. The long term average is about 368,000 claims. The third quarter average for 2000 was only 265,000 claims. The fourth quarter average shot up to 362,000 claims. The first quarter of 2001 averaged 477,000 claims. It then bounced around and hit a quarterly peak of 518,000 in the last quarter of 2001. This was followed by more decreases and fewer increases in subsequent quarters but generally higher than the longer term average of 368,000. See Table One starting below.

Bureau of economic Analysis (BeA). personal income and spending. web site: www.bea.gov/: While statistics gathered by this Govt. agency can be an excellent harbinger of important trends leading up to some recessions, especially Durable Goods expenditures in Table 7, that was not the case in the 2003 recession as spending continued fairly normally during that period.

What happened in the stock markets? The NASDAQ Composite Index which best correlates with Small and Medium Cap companies' ups and downs had a high of 4915 on February 28 2000. By April 1 2000 it dropped to 3817 (a 22% decline). This was followed by modest upticks and further declines to a low of 1140 (a reduction from March 2000 of 77%) by September 30 2002. In April 2003, upturns started to be more consistent and by the yearend was 1938.

Comment: To put the above data in some perspective, it should be underlined that the Stock Market high by the end of February 2000 was to a very high degree a reflection of the so-called dot.com era when any new company start-up whose name ended in –tech. was automatically deemed a winner. Most of these companies bit the dust when the realization finally hit home that their stock prices of 50 or 60 times earnings were unsustainable. This recognition quickly changed the market sentiment of growth at any price to one where value was much more the order of the day. Small stock value funds had positive earnings for the first two years, 2000 and 2001 while the growth funds all took big hits (See the tables of Mutual Fund Yearly Returns, specifically Value vs. Growth Funds. page).

* * *

The 2008 Recession.

While as I noted above, the 2000 recession was the result of wild speculation in the area of technologies, the 2008 recession was largely fueled by the virtual collapse of the housing market. "Easy money" – that is billions of dollars in credit issued for mortgages with too little income on the part of customers to support repayment. These mortgages were typically bundled into securities which were then traded and re-traded. The onset and growth of home foreclosures created huge losses by many banks whose liquidity imploded. Some closed, while others were merged into stronger banks who were assisted by US Government funding. Many banks had insured these securities with AIG (The insurance giant) who then also became illiquid. They too had to be bailed out. In addition, many homeowners used the collateral from their house's ever increasing value to finance other items such as new furniture, new cars etc. When the housing market no longer grew and foreclosures rapidly increased, house values came tumbling down by 30% or more and many homeowners owed more money than their house was worth.

Let us examine how the stock markets and the economic indicators reacted. The NASDAQ Composite Index at the end of 2007 was 2505. Similar numbers were reported for the period January 2 through May. After that, it started to decline, for some three months and then an accelerated decline so that by yearend it was at 1632 (a decline of 35%.) The decline continued until on March 2 it was a low of 1294.


Excerpted from Mutual Fund Small Caps by James Gale Copyright © 2013 by James Gale. Excerpted by permission of AuthorHouse. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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