REPORT ON SMALL-GROWTH MUTUAL FUNDS

Introduction

Small Growth Mutual Funds’ objective is to maximize total return by investing in equity securities of small-growth companies in up-coming industries or young firms in their early growth stages. These funds are normally no-load, no-transaction fee funds investing in technology, health and service. Hence, they provide small investors with a reasonable alternative to direct purchase. Small investors can obtain good returns with the same degree of diversification of value-oriented stocks while avoiding heavy transaction costs.

In this report, we examine the performance of three small-growth funds: Value Line Emerging Opportunities (VLEOX), Turner Emerging Growth Fund (TMCGX) and JP Morgan Small Cap Growth Fund Sel (OGGFX). Then we will recommend the best fund that you should consider to invest in.

Fund Description

VLEOX is an open, medium-growth fund managed by Mr. Stephen E. Grant with the largest assets among the 3 funds (see table 01). TMCGX is a closed, small-growth, youngest and smallest fund managed by a team. OGGFX is an open, small-growth, team-managed and the oldest fund. TMCGX and OGGFX comply with the objective of investing primarily in stocks of small-growth companies in technology, health and service while VLEOX invests primarily in industrial cyclical. According to Morningstar’s rating, TMCGX is one among the top of 10% of the funds in the category since it was incepted. VLEOX and OGGFX are always among the next 22.5% of the fund in the category.

Fund Performance Analysis

Fund total return: According to the data provided by Morningstar, TMCGX had the nearly double quarterly and monthly total returns since inception date (see table 02) compared to the other 2 funds. For example, TMCGX’s total monthly return since inception date was 24.81% vs. 13.92% of VLEOX and 11.08% of OGGFX. OGGFX’s quarterly and monthly total returns since inception date were the lowest among 3 funds. However, there was no such big different among 3 funds in 5-year total returns. TMCGX seemed to have around 5% higher returns than the others.

Total return vs. benchmark: Table 03 represents the yearly total returns of 3 funds vs. Morningstar average category return, which is used as the consistent benchmark of return to compare the returns of 3 funds. Overall, 3 funds outperformed the market but VLEOX and OGGFX underperformed the market in 2003 while TMCGX still outperformed the market. In general, TMCGX always outperformed the market better than the other 2 funds in recent 5 years (see figure 01). This was illustrated by its higher returns compared to benchmark returns. Moreover, TMCGX’ performance to outperform the market was much more stable than the others. In other words, TMCGX’s performance has been consistent in excess return vs. benchmark.

Risk: As TMCGX had highest return, it seemed to have highest total risks among 3 funds. TMCGX’s standard deviation in 3 years is 15.24% vs. 14.52% (OGGFX) and 11.93% (VLEOX). Although 3 funds had higher Beta than market Beta, TMCGX had the highest Beta (1.59), then OGGFX with 1.49 and VLEOX with 1.21. The reason why VLEOX had the lowest total and nondiversifiable risks is that VLEOX is a medium-growth fund and it invests primarily in equity of medium-growth firms in industrial cyclical rather than investing in equity of young firms or firms in new industries that bear high risk.

Excess return:

VLEOX and OGGFX had negative Alpha (see table 04), which means that both of them underperformed the index (benchmark return) relative to how much volatility has been shown, or their actual returns are lower than their expected returns. On the other hand, TMCGX could achieve an actual return higher than its expected return by 1.31%. TMCGX also achieved greater return per unit of risk than the others (highest Sharpe ratio).

The excess return may due to selectivity rather than diversification. From table 05, we notice that VLEOX and OGGFX were more diversified than TMCGX in terms of numbers of stocks held but they had negative excess returns as discussed above. Moreover, they hold almost all domestic stocks and invest more than 90% of their fund capital in stocks (table 04). Meanwhile, TMCGX invested only 82.22% of its capital in stocks, kept 12.48% cash as a safe option and invested more than 2% in foreign stocks. Therefore, we see that the performance of small-growth mutual funds is not largely influenced by diversification but rather depends mainly on assets allocation and the choice of stocks in their portfolios. This means that the fund performance depends on fund management, which will be discussed later in this report.

Fund management:

We assess the management performance of each fund based on return from fund managers’ risk, which is return on the risk that fund managers take to manage fund assets. Given the desired non-diversifiable risk level at market Beta (beta=1), TMCGX had the largest return from manager’s risk 5.28% vs. 4.26% of OGGFX and 1.82% of VLEOX. Please see the table 06 for detailed calculation method. This means that TMCGX was best managed among 3 funds and OGGFX was well managed. Therefore, we see that fund performance depends largely on how well the fund is managed.

The 3 funds differ in their investment strategies. While TMCGX invests in diversified portfolios of companies that it believes have strong earnings prospects in emerging industries like health and technology, OGGFX invests in stocks of growth companies with leading competitive positions and seeks companies with predictable and durable business models capable of achieving sustainable growth. VLEOX focuses on companies that have expertise, theme or industry knowledge by stocks screening and fundamental analysis to identify companies that will provide super earnings. We see that the action of TMCGX is consistent with the stated objective of the small-growth fund but the actions of the other funds are not. As TMCGX seems to have the best performance, we are quite confident that it is better for investors to invest in a mutual fund that acts consistently with its objective.

Fund Prospect: VLEOX had the fastest growth rate of assets and largest fund size among 3 funds (see table 07). However, its performance in terms of total return was not better than the performance of TMCGX which is the smallest fund. This means that fund performance does not necessarily depend on the fund size and fund asset growth rate. Therefore, when making investment decisions, the investor should not look at the fund size and fund growth rate but rather examine the management quality of the fund under consideration.

Purchase and Expenses: OGGFX had the highest turnover rate (120%, table 04) but its performance was not the best. This is because this fund had higher transaction costs due to high turnover rate and fund performance is examined after all transaction costs. As a result, OGGFX appeared to perform worse than TMCGX due to more expensive transaction costs but not due to managers’ ability. Therefore, funds with low turnover rates seemed to outperform funds with high turnover rates. On the other hand, TMCGX has the largest expenses ratio so the fund might risk having poorer performance if its extra return is not sufficient enough to cover expenses.

Strengths and weaknesses of the funds: All three funds have ability to outperform the market and provide higher returns to the investor than the market return. They have good fund management and assets allocation to achieve differential return as well as low transaction expenses. However, all of them tend to volatile closely with market movement and bear high nondiversifiable risk. Please refer to table 08 for further details.

Conclusion

The overall performance of a mutual fund is not related to its size but depends on the fund’s investment objective, expenses ratio, turnover rates and especially the ability of fund managers. The ability to outperform the market of a fund relies more on the selectivity than on diversification of the fund’s portfolio.

There are some criteria for investment decisions in small-growth funds: investment objective, expenses ratio, turnover rates. More important criteria are the fund’s investment strategy, Alpha or excess return, fund management and asset allocation.

Based on our above analysis, we recommend that the investor should invest in TMCGX fund. However, OGGFX is a good alternative because this fund’s performance and management quality are very near to that of TMCGX.