Is your small-cap fund cheating? Managers say they can't find companies small enough

Kiplinger's Personal Finance Magazine, Sept, 1998

Managers say they can't find companies small enough.

What is a small-company stock anyway? A report that two leading mutual fund data gatherers, Morningstar and Lipper Analytical Services, were considering revising their definitions of small-company stock funds has made this a hot-button topic.

The issue is important for several reasons. Small-company stocks often behave differently than stocks of larger companies. Moreover, some companies that began the decade as truly small have appreciated in stock-market value to the point that they are large by any definition. And some investors, as well as consultants who advise companies on choosing funds for use in pension plans, like to make sure that funds adhere to a style.

Managers of small-company funds in particular are pushing for change, says John Rekenthaler, Morningstar's research director. They're "squawking," he says, about having to sell good stocks that have appreciated beyond the small-stock range to remain true to their categorizations.

At Morningstar, a small-company fund is one whose median market capitalization is less than $1 billion. Rekenthaler says that Morningstar may adopt a floating standard that adjusts boundaries in response to changes in the overall stock market.

But some consultants object. They reason that if a fund's typical holding has grown in stock-market value over the years from, say, $500 million to $2 billion, the fund's basic character has changed. Moreover, because of this "style drift," the fund no longer fulfills the reason it was included in an investor's portfolio. Claudia Mott, a small-company-stock analyst at Prudential Securities, is more blunt: "Raising the market-cap hurdles just allows people to cheat."

All this talk about style drift is so much hot air to many fund managers, who say that, more often than not, a fund seeks to adhere to a strategy of investing rather than a numerically defined style. Says Steven Reid, who runs Oakmark Small Cap fund: "It drives me crazy when a small-cap manager sells a stock at a billion dollars even though he thinks it's worth a billion and a half, just because he doesn't want to cross the line."