Small-cap strategies are big news again.
Pension funds have been conducting more domestic small-cap searches in recent months than they have in the past 10 years, say money managers and industry consultants.
While hard data is not available, anecdotally there has been a lot of activity, judging by the slew of announcements in recent weeks. Here is a sampling:
*The $7 billion Ohio School Employees' Retirement System, Columbus, hired three small-cap equity managers, giving them $40 million apiece;
*The $74 million Jersey City (N.J.) Employees' Retirement System doubled its domestic small-cap equity allocation to 10% of assets;
*The $150 million Brockton (Mass.) Contributory Retirement System two managers to run small-cap value small-cap growth portfolios;
*Carpenter Technology Corp., Reading, Pa., hired three small-cap equity managers;
*The $4.6 billion West Virginia Investment Management Board, Charleston, W.Va., hired three small-cap managers, giving them $125 million each;
*The $55 million Woburn, (Mass) Retirement System announced plans to convert a domestic large-cap value portfolio into domestic small-cap value and midcap growth value portfolios as well as search for a new manager to run a domestic small-cap growth portfolio.
*The $103 million Rockford (Ill.) Fire Pension Fund plans to hire its first small-cap equity manager soon;
*The $3 billion San Bernardino County Employees Retirement Association issued RFPs for a small-cap value manager.
The reasons vary. Many searches are for replacement managers. Others have resulted from a rebalancing of portfolios that became overweighted in large-cap investments after a big runup from the bull market. Some searches were spurred by the invitingly low valuations of small-cap stocks that got beaten up in the August and September market correction, which in turn created buying opportunities.
And some pension fund clients are switching out of small-cap and midcap passive strategies to small-cap and midcap active strategies, because they believe it's the best way to add value to their holdings, said Paul Greenwood, senior research analyst, Frank Russell Co., Tacoma, Wash.
"Clients have become frustrated finding active managers to outperform the large-cap indexes," Mr. Greenwood said. "Most see more promise in small cap. Increasingly, there seems to be a belief that active management is best in small cap."
And, the interest is across the board, from growth to value to core strategies.
He doesn't think the low valuations of small-cap stocks is the catalyst behind the searches he's seen, because Frank Russell's clients tend to be large pension funds that can't act quickly.
In the quarter ended Sept. 30, the Standard & Poor's 500 stock index fell 10%; the Russell 2000 Index slid 20.1% and the Russell Midcap fell 14.8% in the period. For the year ended Sept. 30, the S&P 500 rose 9% compared with the year-ago period; the Russell 2000 fell 19% and the Russell Midcap fell 6%.
Bruce Pflug, director of consultant development at BEA Associates, New York, believes many of the recent searches for small-cap managers are due to money managers' inability to be "nimble. The world has changed in the last 10 years, in terms of what constitutes small cap. The definition of small cap has evolved from companies capitalized under $5 billion to those under $1 billion.
"At the same time, the definition of microcap also changed from companies whose market cap is under $500 million to under $250 million. Many managers weren't applying themselves well enough to these broader definitions."
Now, pension funds that never were in small cap are moving into the area, and in other cases are looking for replacement managers that can be nimble, Mr. Pflug said.
Plus, some of the small-cap managers in the '80s didn't use specific styles, whereas the pension executives conducting searches now are seeking specific styles to help diversify their portfolios.
He estimates the number of small-cap searches in which BEA has participated this year is up 50% from 1997.
Claudia Mott, director of small-cap research at Prudential Securities, New York, said the outlook for small caps is the best it has been in four years. The lust for large-cap stocks is gone, in large part because foreign buyers have retreated and large-cap investors have been moving into other mandates.
Ms. Mott is so bullish on small caps, she had bumper stickers made up reading "Have you hugged your small-cap manager lately?" and she's been distributing them to clients.
Many institutional investors have been moving money into small-cap funds as they reshuffle managers or try to get their asset allocations back to their targets, she said.
She predicted small caps will outperform over the next six to 12 months if the strong fundamentals of the U.S. economy don't change.
The sectors that are most likely to do well include technology, health care and consumer services. In the spring, if small caps are still going strong, she predicts a shift to more value-oriented sectors, such as cyclicals and finance.
Not everyone is seeing an uptick, however. Tom Anichini, principal with William M. Mercer Investment Consulting Inc., Deerfield, Ill., said the firm assisted in 39 small-cap searches in 1997, and around 37 for the year to date, which he expects will end even with 1997. "There has been a steady flow both years," he said.
Searches can be tough, however, because a number of firms have closed their small-cap business in order to keep assets below a certain level, necessary for efficient investing.
Don Ceglar, managing director of Weiss Peck & Greer LLC in New York, said the firm's small-cap business has been closed for three to four years.
"Most good managers get closed quickly," he said. "But we get calls about them (the small-cap funds) all the time."
The story is similar at Cadence Capital Management, Boston, where the small-cap business closed to new investors in 1992. However, it recently received additional money from the $74 million Jersey City Retirement System, which doubled its small-cap equity allocation.
Mike Skillman, director of account management at Cadence, said the fund was able to take an additional allocation from Jersey City because another client had pulled out some money, which it is redeploying into a large-cap strategy.
"There has been tremendous interest in small caps the last six months, and that has increased dramatically in just the last month," Mr. Skillman said.
Clients are particularly interested in growth strategies, he said.
One reason is the valuations, which are at 20-year lows. Although many large public pension funds are unable to jump on the good buys, because of all the approval processes they must go through first, corporate pension funds and sophisticated endowments are acting faster to take advantage of good buying opportunities.
Another reason is the rebalancing going on at many large funds, where domestic large-cap investments have moved above their targets.
"We can't take any more than the $900 million we are currently managing in small-cap accounts," Mr. Skillman said.
"So, we are referring callers to other managers who are still open such as Artisan Partners (LP) in Milwaukee and LSV Asset Management, Chicago." He added that many clients are also showing new interest in midcap funds as a separate asset class, which is helping that business flourish.
Dick Zaccaro, a consultant at H.C. Wainwright, Boston, said he had been involved in a number of small-cap searches in the past two years, as part of his basic recommendations, which always include a variety of strategies for diversification purposes. But he believes the third-quarter correction has stimulated activity in general, particularly in value strategies.
