Lord Abbett Developing Growth, one of the oldest funds in the small-cap category, launched in 1973, follows a solid growth strategy. O'Halloran looks for "best of breed" companies in the small-cap arena enjoying strong revenue and earnings growth. They must have a resemblance to a successful larger company. Morningstar, for example, has been a holding for three years. "When we bought it on its IPO in the first half of 2004, we characterized it as a baby Moody's [Investors Service]," says O'Halloran.
He sees future growth opportunities in both Internet and alternative energy stocks. On the Internet side, he especially likes Equinix (EQIX) whose server "farms" host traffic across the Internet. A favorite alternative energy stock is Solar Energy (SPWF).
The Perkins Discovery Fund has been among Morningstar's top funds in its category. Since its birth in 1998, the fund has posted a 19.14% annualized return through June 2007. And over the past five years through June, it has returned 21% on an annualized basis, compared with 13.87% for the Russell 2000 index.
The fund has a bottom-up approach, meaning it looks for stocks one by one, as opposed to by sectors. The bulk of its 64-stock portfolio is in medical, technology, software and energy, all sectors the managers are betting on for the future. A favorite medical stock is Matrix Initiatives (MPXX), which produces cold remedies. Union Drilling (UDRL), which operates and leases out close to 80 natural gas drilling rigs, is another favorite, along with Vivus (VVUS), whose current products are primarily for erectile dysfunction.
Financial Advisory Consultants, with $167 million under management, is holding its small-cap allocations steady. Says Merkel: "Even considering the pressure we've received from some clients to eliminate small-cap growth funds, due to their underperformance compared with small-cap value funds, we've encouraged clients to hold their small-cap growth positions. We don't think you should give up on small-cap value or small-cap growth, and move into larger caps. You'd be setting yourself up for failure."
He adds: "It's kind of the theory that every dog has its day. Small-cap value will outperform small-cap growth in certain time periods, and the reverse is true for others. The most difficult thing is controlling that irrational behavior of clients."
Greene is holding firm as well. "At this juncture, we are not reducing our allocations. We have a minimum allocation to small caps, typically 2% to 4%, depending on the client. We have also been overweighted in large-cap funds for some time. It's important to remember, however, that for long-term investors, small-cap funds have outperformed large cap; therefore, we maintain an allocation."
Greene especially likes Heartland Value Fund, a small-cap value fund in existence since 1984 with the same manager. "They utilize a vigorous screening program and have had favorable long-term performance results," he says.
Other advisors, however, are not waiting for the dust to settle. Lewis J. Altfest, CFP, CFA, CPA, a principal of L.J. Altfest & Co., a wealth management firm in New York with $500 million under management, cut his firm's small-cap fund allocations from 10% to 6% some time ago, he says. Meanwhile, he has upped his large-cap fund exposure from 18% to 24% of clients' portfolios.
"It just seemed to us we weren't getting good valuations from small-cap funds," says Altfest. "Valuations are about at their highs relative to large-cap funds. The standard deviation for small caps is right alongside that for international stocks."