Small-cap mutual funds had a strong showing in the second quarter, replacing growth funds as the top performers among bank and thrift-managed equity funds.
Reversing a five-year trend, small-cap funds dominated a list of the top 50 bank and thrift-managed funds compiled by Wiesenberger of Rockville, Md., a Thomson Financial company. A year ago the same list consisted almost entirely of large-cap domestic growth funds.
Fund managers and analysts attributed the shift to a longstanding undervaluation of small stocks, generally defined as those having a market capitalization below $1.5 billion.
After last year's market downturn, analysts slashed estimates on small-caps so far back that earnings now look great compared to expectations, said Joseph A. Frohna, a senior portfolio manager at Firstar Investment Research and Management Co., the investment subsidiary of Firstar Corp. of Milwaukee.
We've seen a lot of small-cap companies outperform and beat their numbers, he said.
Furthermore, relatively low small-cap stock prices have fueled acquisitions by large-cap companies, adding to the small stocks' performance, said Mr. Frohna.
Firstar's Micro Cap fund had the highest total return among bank-managed funds in the quarter, at 31.05%. The Small Company Value fund of New York-based Dreyfus Corp., a subsidiary of Mellon Bank Corp. of Pittsburgh, finished second, with a 29.42% return.
Mr. Frohna attributed the Micro Cap fund's success to investments in the wireless telecommunications, Internet, and oil and gas sectors, coupled with the growth of small-cap stocks overall.
Albin S. Dubiak, the managing director of U.S. Bancorp's First American Funds, said that investments in oil services companies had contributed to the success of his Regional Equity Fund, which returned 24.14% in the quarter.
For Mr. Dubiak low valuations of small stocks are still the driving force behind the funds' growth. On a historical basis small-cap stocks are still near the bottom, he said.
A lot of it is just relative, said Michael T. Gaul, an equity fund analyst at Morningstar Inc. in Chicago. Larger stocks, he said, got overvalued while investors ignored small-cap value funds.
With the shake-up in the market, people are finding a lot of value in small-caps, he said.
Mr. Gaul said that small-cap funds had already slowed down in the third quarter, though, he said, small-stock valuations remain attractive compared with those of large-cap stocks.
But there may be a hint of trouble on the horizon. Robert W. Bissell, the president of Wells Capital Management Inc., the investment arm of San Francisco-based Wells Fargo & Co., said that nervousness about interest rates could have a negative impact on small-cap fund performance in the near term.
When people become uncertain, they become very conservative, he said. However, smaller companies perform better relative to their larger counterparts in a slower economy, he added.