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November 12, 2007 12:00 AM

Equity funds: Midcap, small-cap strategies dominate

JENNIFER BYRD
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    Meighan Harahan’s underweighting of housing and financial services helped Driehaus’ fund performance.

    Midcap and small-cap growth equity strategies dominated Morningstar’s Separate Account/CIT Fund Database for the year ended Sept. 30.

    The top three portfolios were all midcaps. Insight Capital Research & Management Inc., Walnut Creek, Calif., was the No. 1 manager in the composite U.S. stocks segment with a gross return of 65.11% for its all-cap growth portfolio, which Morningstar categorizes as a midcap strategy. Chicago-based Driehaus Capital Management LLC was No. 2 with its midcap growth portfolio, which yielded 60.96%. Harman Investment Advisors, Chicago, was third with its core equity composite portfolio at 56.76%.

    Insight took fourth and fifth places with its small-cap growth strategy at 56.44% and its midcap growth strategy at 56.26%.

    The Russell 3000 returned 16.52% for the year, while the median fund in the composite U.S. stock segment returned 17.29%.

    Steve Deutsch, Morningstar’s director of separate accounts and collective investment trusts, said one interesting factor for the quarter was how quickly real estate strategies disappeared from the top of the list.

    “In past quarters, we’ve seen a strong indication that real estate was driving a lot of the top performance,” Mr. Deutsch said. “Now, we have to conclude that outstanding returns from real estate have definitely faded.”

    Recent troubles in the subprime mortgage market and the resulting credit crunch contributed to real estate-driven strategies not performing well, he said. Many of the top portfolios had skilled managers picking hot stocks in the midcap and small-cap growth areas that produced alpha, he said.

    Rapid growth

    Lee Molendyk, co-portfolio manager of the Insight all-cap growth and small-cap growth strategies with Lance Swanson, said both portfolios benefited from investments in small-cap companies that are growing rapidly. Mr. Molendyk said the portfolios look to invest in stocks that are growing at four times the rate of the U.S. gross domestic product.

    The all-cap portfolio currently has about 40 stocks and ranges between 30 and 50. It has a turnover rate of about 200%. Holdings in Crocs Inc., Priceline.com Inc., Blue Coat Systems Inc. and DryShips Inc. had positive returns for the year and helped contribute to the all-cap portfolio’s performance.

    “It’s an aggressive growth portfolio,” Mr. Molendyk. “We’re typically bottom-up stock pickers. We rarely take a top-down view of the market and benefited from a few specialty products that were exploiting certain market niches.

    DryShips, which specializes in the transportation of dry bulk cargo, was a particularly strong contributor, Mr. Molendyk said, because of the strong need for natural resource transportation globally, particularly in China.

    “The world is growing at a faster rate than ships are coming online,” he said.

    The all-cap and small-cap strategies own many of the same stocks, but the all-cap portfolio’s holdings in large-cap Research in Motion Ltd., made the biggest difference in performance between the two strategies, Mr. Molendyk said.

    Meighan Harahan, portfolio manager of the Driehaus midcap growth portfolio, said holdings in the materials, energy and industrials, technology and health-care sectors contributed to that strategy’s performance.

    “We’re very opportunistic. That’s one of Driehaus’ franchises: We look for change, we look for growth,” she said.

    One example of a hot stock in the portfolio was Intuitive Surgical Inc., which makes robotics technology used for the surgical treatment for prostate cancer. It cuts down on hospital time and patients have a quicker recovery time than if they have a traditional procedure. Ms. Harahan said she thinks the stock will continue to grow because the robotic procedure can apply to other types of surgeries.

    In addition, holdings in Baidu.com Inc., National Oilwell Varco Inc., Foster Wheeler Ltd., Wynn Resorts Ltd., and First Solar Inc. were winners for the portfolio, Ms. Harahan said. A lack of exposure to the financial and housing sectors also added to performance.

    “We benefited from having underweighted that sector because of what’s happening in the market.”

    Concentrated

    Doug Harman, president and chief compliance officer at Harman Investment Advisors, said its core equity composite portfolio is more of a midcap to large-cap value orientation, although Morningstar classifies it as midcap blend. He said it’s a concentrated portfolio of 20 stocks, with the bulk of holdings in the energy and industrial sectors.

    He said a decision to move into agriculture stocks last fall and energy stocks in the spring accounted for the strategies positive performance for the year.

    American Century Investments, Kansas City, Mo., was sixth with its midcap core growth strategy, which returned 54.79%.

    The strategy uses a bottom-up stock picking process that looks for companies with great acceleration and relative price strength, said David Hollond, portfolio manager. Global demand for infrastructure improvements in emerging markets have led to good performance in the industrial sector, he said.

    “A number of U.S. industrial and energy companies are supplying goods and services world wide,” he said. “The key was finding that and finding it earlier than a lot of other people.”

    In addition to industrial stocks, other strong holdings were BE Aerospace Inc. and Gamestop Corp., Mr. Hollond said.

    BE Aerospace manufactures cabin interiors for commercial aircraft and business jets. Growing demand for planes in emerging markets has been good for the stock. Mr. Hollond said he thinks the company will continue to grow because aging U.S. planes will need to be replaced. And airplanes are getting larger too. “With the larger aircrafts, each order is worth a lot more,” he said.

    The growing video gaming industry has fed into Gamestop’s success, which has seen growth in the U.S. and expansion into Europe. Even with economic problems like high housing costs and the credit crunch, consumers are continuing to buy video games, Mr. Hollond said.

    Rounding out the top 10 were Driehaus, with 53.75% for its small-cap growth strategy and 52.60% for its micro-cap growth strategy; Columbus Circle Investors, Stamford, Conn., 52.48% for its small-cap equity growth strategy, and Driehaus, 47.94% for its midcap recovery growth strategy.

    For the five years ended Sept. 30, Trapeze Asset Management Inc., Toronto, came in first with a gross annualized return of 50.18% for its long-only equity strategy, followed by the Trapeze long/short equity strategy at 42.55%; and the Value Works LLC, New York, 125/25 hedged strategy, with 39.6%. Boston-based Wellington Management Co. LLP was fourth for its energy strategy with 39.02%, while Investment Management of Virginia LLC, Richmond, was fifth with its energy portfolio at 36.34%.

    The Russell 3000 returned 16.18% for the five-year period, while the median account in the Morningstar database returned 18.03%.

    In the Morningstar U.S. stock collective investment trust sector, large-cap growth managers took the top three spots for the year ended Sept. 30, with two mid-cap growth strategies coming in fourth and fifth.

    Janus Capital Group, Denver, was first and second for the year with its institutional diversified growth fund, which returned a gross 42.75%, and its institutional aggressive growth commingled fund at 39.55%. UBS Fiduciary Trust, New York, was third with its aggressive growth fund at 33.31%, followed by Frontier Capital Management Co. LLC, Boston, with its research fund at 33.27% and the midcap growth fund of Prudential Retirement, Newark, N.J., at 32.27%.

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