Top-performing equity managers: Small-cap funds weather market plunge

A volatile third quarter sent equity returns plummeting in Morningstar Inc.'s separate account/collective trust database for equity strategies.

Small-capitalization stocks continued to lead the one-year returns as of Sept. 30, but those strategies were buoyed by strong previous quarters, said Adam Baranowski, a data analyst with Morningstar in Chicago. Six of the top 10 portfolios in Morningstar's separate account U.S. equity universe for the 12-month period — including Nos. 1 and 2 — were small-cap strategies, which have dominated the list for five straight quarters.

Still, the plummeting returns caused a major shake-up in the rankings.

While there typically are several holdover strategies in the top 10 each quarter, only 12th Street Asset Management LLC's asset opportunity strategy was in the top 10 for the year ended Sept. 30, compared with the June 30 ranking.

“What stuck out to me was the high turnover of strategies on this top 10 list compared to the list last quarter,” Mr. Baranowski said. “The main story here is the poor overall performance of the equity strategies as a whole in the third quarter.” The median return for the equity universe was -17% for the quarter. Mr. Baranowski said the shake-up came because last quarter's top strategies did not perform well, not because the influx of new portfolios performed strongly.

Only three of the top 10 had positive returns in the third quarter.

The median returns for all broad equity classes were negative in the third quarter; the first time that has happened since the first quarter of 2009, Mr. Baranowski said. Small-cap strategies had the highest returns in the second quarter, but were the worst domestic categories in the third quarter returning -21.65% for growth, -21.24% for blend and -20.91% for value strategies, he said.

The Russell 3000 index returned -15.28% for the quarter and just 0.55% for the year ended Sept. 30.

12th Street Asset Management took the top two spots for both one-year and five-year returns with its small-cap value and asset opportunity portfolios, respectively. The small-cap value strategy returned 30.19% for the year ended Sept. 30 and a compound annualized return of 28.99% for five years. (All returns for periods of more than one year are compound annualized figures.)

The all-cap asset opportunity strategy returned 24.92% for the year and 24.48% for the five-year returns. Both portfolios had quarterly returns around -10%.

“One thing that makes us different is our focus on a process rather than managing to a return,” said Michael O'Keefe, founding partner of the Chicago-based firm. “We don't diversify to reduce risk, but invest with a margin of safety and a best-idea approach.”

“We allocate capital based on our highest conviction, not managing to a benchmark,” Mr. O'Keefe said.

This was the first quarter 12th Street reported the strategy, which holds the small-cap stocks of the asset opportunity portfolio. There is little exposure in both to the technology sector with more holdings in transportation, paper, pulp and retail areas.

Buckeye Technologies Inc. continues to be a strong performer for both 12th Street portfolios, Mr. O'Keefe said. He expects good things from the company going forward, in part because another price increase for cellulose, the “crown jewel” of the manufacturer, is on the way in January. The firm bought the stock when it was in the lower single digits, Mr. O'Keefe said; it closed Nov. 1 at $29.50.

Successful holdings over the past few years include Monro Muffler Brake Inc., FedEx Corp., Nalco Holding Co. and J.B. Hunt Transport Services Inc., Mr. O'Keefe said. All but Nalco are still in the portfolio.

12th Street's portfolios were followed in the one-year returns by the special situation property real estate strategy of J.P. Morgan Asset Management Inc., which returned 24.37%. Rounding out the top five were San Diego-based Rice Hall James & Associates LLC's small-cap growth strategy with 20.04%, and Boston-based Ironwood Investment Management LLC's concentrated small-cap value portfolio with 19.71%.

Cara Thome, lead portfolio manager on the Rice Hall James portfolio, said health-care holdings performed very well in the 12 months, as well as consumer staples and technology stocks, although the portfolio does not target specific sectors. She said the team seeks out companies that are not well understood or well-followed by Wall Street, such as Questcor Pharmaceuticals Inc., which she called a “monster stock” in the last year. The portfolio purchased the stock last October and sold it at the end of September after its success with the expansion of the drug Acthar.

“We continue to be always looking for unique ideas,” Ms. Thome said. “We find growth stocks that are trading at a valuation that doesn't reflect the growth.”

The portfolio typically holds 40 to 60 stocks with a turnover rate of 70%. The strategy has $585 million in total assets, from mutual fund and separate accounts. Other strong performing holdings include Pricesmart Inc., which operates warehouse club stores in Central America and the Caribbean, and technology companies Polycom Inc. and FEI Co.

Warren Isabelle, managing director and founder of Ironwood, and portfolio manager of the concentrated small-cap value strategy, said the fund exploits market volatility in the U.S. small-cap markets by looking for steep price declines as the entry point for fundamental analysis.

“We look for a huge disparity in the economic value over what people are valuing the stock at,” Mr. Isabelle said. “We're looking for real businesses as if we would own them ourselves.”

The $5 million strategy has about 20 stocks with a turnover rate of 20% to 33% and has seen big boosts from holdings in biotechnology companies such as Spectrum Pharmaceuticals Inc., Ariad Pharmaceuticals Inc. Mr. Isabelle said the portfolio sold Ariad in the summer, returning six times the original investment, and recently sold Farrel stock at $15 after originally purchasing the stock for around $5. The stock has dropped to $6 since, and Mr. Isabelle said he has reinvested in the company. CPI Aerostructures Inc. was another big winner for Ironwood. “CPI blossomed very nicely into an assembler of aircraft components,” Mr. Isabelle said.

In the five-year rankings, AIS Capital Management LLC's TAAP portfolio — with a compound annualized 19.01% — came in third behind the 12th Street strategies. The TAAP precious metals strategy also ranked sixth in the one-year returns and was one of only three strategies to have positive returns in the third quarter. Following AIS was Tocqueville Asset Management LP's gold equity strategy, which returned 18.09%, and Insight Capital Research & Management Inc.'s concentrated growth midcap strategy with 17.19%.

For the five years, the median return was 0.29%, and the Russell 3000 returned -0.92%.

Tocqueville's gold equity strategy has continued to perform well with low interest rates and a loss of faith in paper currency, said John Hathaway, New York-based senior managing director and portfolio manager of the strategy. The portfolio was started in 1998 when the gold market bottomed out and tends to hold onto stocks for long periods of time. Mr. Hathaway said the portfolio consists of 60 to 70 stocks with a turnover rate of 10%.

“Basically, we haven't changed what we do for a long time,” Mr. Hathaway said. “The ideal scenario is to find a company in the early stage of development ... that needs capital to get larger and grow.”

The $3.2 billion fund invests in the entire gold spectrum, but scales more to smaller companies with an average market cap of 60% compared to peers, Mr. Hathaway said. Some of the successful companies in the portfolio include Osisko Mining Corp., Randgold Resources Ltd. and Goldcorp Inc. Mr. Hathaway said the fund invested in Osisko about six years ago and has seen the market capitalization go from a couple hundred million dollars to $5 billion.

Among collective trusts, Amalgamated Bank's Longview 600 small-cap index fund was first for the one-year ranking with a return of 23.07%, while the real estate fund of ASB Capital Management LLC was second with 18.56%. Amalgamated Bank's Longview 500 large-cap index fund was third with 16.45%, followed by Washington Capital Management Inc.'s real estate equity fund with 13.64% and State Street Global Advisors' Nasdaq 100 index fund with 8.06%.

The medians in the collective trust universe were -0.12% for the one-year period and -0.79% for the five years.

For the five years ended Sept. 30, Schroder Alternative Solutions' commodities fund was first among collective trusts with an annualized return of 6.57%. In second was the Speece Thorson Capital Group Inc.'s value fund with 6.42%, followed by Champlain Investment Partners LLC's small-company fund with a return of 6.19%. Fourth place belonged to Westwood Management Corp.'s smidcap blend fund, returning 5.9%, while Pyramis Global Advisors' midcap core fund tied with SSgA's Nasdaq 100 index fund at 5.87%.