Small caps push REITs off of center stage for the year

Small-cap growth strategies dominated the overall domestic equity rankings in the year ended June 30, edging out strategies built on real estate investment trusts, according to Morningstar Inc.'s separate account/collective investment trust database.

Eight of the top 10 equity strategies were small-cap strategies, of which seven were small-cap growth. That represents a significant upheaval from the previous two quarters, which saw real estate investment trusts dominating the top 10 overall equity strategies.

Daniel Culloton, associate director of manager research, equity strategies, at Morningstar in Chicago, said domestic small-cap growth equity strategies in general have had a very strong year.

“Managers focused on small-cap growth, particularly on microcap, and with those with a fair amount of health care — particularly biotechnology — and some technology stocks, those are the ones that have clustered up on the top,” Mr. Culloton said in an interview.

While the Russell 3000 index returned 7.3% in the year ended June 20, the Russell 2000 Growth index returned 12.3%. (The median return for the 12-month period for domestic equity managers in Morningstar's database was 6.96%.)

“If you look at the Morningstar indexes over the trailing year, growth generally has beaten value and large has tended to beat small, except in the case of small growth and midcap growth,” Mr. Culloton said.

“Some would attribute this to the fact that the Fed policy is still very loose. There's some speculation still when the Fed's going to increase rates and what effect that's going to have on a variety of markets and also equity.

“It'll be interesting to see how long growth continues to outperform value,” Mr. Culloton said. “That always inevitably switches, I can remember not so long ago that people were wondering when growth was going to outperform value, even through 2008, 2009, 2010. It's only been within recent years that growth has come to the fore.”

The top performing manager was Mazama Capital Management Inc., returning a gross 37.7% in the year ended June 30, for its emerging manager small-cap growth strategy. That strategy has led the overall domestic equity ranks for the past three consecutive quarters.

The average weighted market cap of the younger companies the Mazama portfolio targets is $1 billion, compared with the average weighted market cap of the Russell 2000 at $2 billion.

Ron A. Sauer, founder, CEO and chief investment officer of Portland, Ore.-based Mazama, said one of the primary contributors to the success not only of his firm's strategies, but also small-cap growth strategies across the board compared with large caps, has been the minimal exposure to international currencies.

Mazama ranked third with its small-midcap growth strategy, which returned a gross 27.1% in the year ended June 30.

Mr. Sauer said technology and health-care companies were the top two outperformers for both the strategies. One significant contributor was Diplomat Pharmacy Inc.

Ranking second was Financial Trust Asset Management's health value strategy, which returned a gross 31.1% in the year ended June 30.

The strategy has remained consistent since its inception in May 2001, with a rules-based value orientation, said Arno O. Mayer, founder and president of the Boca Raton, Fla.-based money manager.

The portfolio always has 50 holdings in health-care companies across all sectors. The portfolio is rebalanced monthly to maintain 2% in each stock, Mr. Mayer said.

“By keeping our positions at 2%, no one position contributed in our success,” he said. “We're really sector diversified, from health maintenance organizations to hospitals, to a little bit of biotechnology within the portfolio, but not a lot.”

“Really it's not been a focus on one area of the health-care industry,” Mr. Mayer added.

Private Capital Management LLC, Naples, Fla., ranked fourth overall with its value-focus strategy, which had a gross return of 25.9% for the year ended June 30.

“Our focus is individual stock selection and valuation work at the company level,” said Jeffrey Fortier, managing director.

The “reasonably concentrated” strategy has 25 to 30 names “that allows for individual research ... to be impactful to performance.”

Mr. Fortier said Vasco Data Security International Inc. was a key contributor in the tech sector and also said security businesses and health care in general were strong sectors for the strategy.

Among the strategy's top health-care holdings are Actavis PLC and Valeant Pharmaceuticals International Inc.

“It's a nice time to be a stock picker,” Mr. Fortier said. “Our outlook is that valuations have largely normalized and running strategies that enable individual stock selection and research to be impactful are the places to be.”

RS Investment Management Co. LLC's small-cap growth strategy ranked fifth overall with a gross return of 25.4% in the year ended June 30.

Scott Tracy, portfolio manager and head of the growth group at the San Francisco-based money manager, said the strategy is a bottom-up fundamental one in which the team searches for companies for sustainable growth over a multiyear horizon.

“We try to find companies that can compound earnings growth over a three- to five-year period and really allow their stock to perform,” Mr. Tracy said.

“We're not benchmark huggers. We're just benchmark aware,” said Mr. Tracy, “and we like to diversify our risk along many sectors.”

Among top performing sectors for the strategy have been technology and health care, along with financial services. In the latter sector, MarketAxess Holdings Inc. has done very well for the strategy, Mr. Tracy said.

“That (stock) was up 74% over the last year and that really exemplifies our process because we have owned it for over five years,” Mr. Tracy said.

He said portfolio managers originally picked the stock early in its life because they expected Market-Axess could capture a significant share of the electronic bonds trading market.

“We sit here five years later, and the stock is in the high 90s, over sixfold over the last five years,” he said.

For the five years ended June 30, small-cap strategies again dominated, but with more of a mix between value and growth. The core composite strategy of Naylor & Co. — a midcap growth approach — topped the ranking with an annualized gross return of 32.6%.

Financial Trust's health value strategy ranked second, with an annualized gross return of 27.3%, followed by Mazama's emerging small-cap growth strategy at 27.2%; Granahan Investment Management's small-cap focused growth strategy, 25.6%; and Allianz Global Investors' ultra microcap strategy at 25.2%. (All returns for periods of more than one year are annualized.)

The median five-year return was 17.6%, while the Russell 3000 index returned 17.5%.

Among collective investment trusts, the J.P. Morgan Chase Bank large-cap growth strategy was the top performer, with a one-year net return of 16.6% as of June 30.

J.P. Morgan Chase Bank also ranked second among CITs, with its all-cap growth strategy returning a net 16.46% for the 12 months.

Rounding out the top five CITs for the year were: William Blair & Co.'s small-midcap growth strategy, with a net return of 15.7%; State Street Global Advisors' NASDAQ 100 index fund, a net 15.5%;, and BlackRock Inc.'s U.S. fundamental large-cap growth CIT, 15.3%.

All of the data for Pensions & Investments' quarterly top-performing managers report are provided from Morningstar's global separate account/collective investment trust database. The rankings that run in print were pulled from Morningstar data available on July 23; online rankings might differ. For information on the database, please contact separate [email protected] or call 312-384-4087.