Uncovering small gems in the fund industry's coal pile

Aaron Pressman

There are a zillion ways to screen for mutual funds, some backed by academic research and empirical evidence, others less so. But one flaw I often notice in these automated fund screens and analyst fund ratings is their inability to uncover promising new funds. Managers with lengthy track records of outperformance tend to attract more and more money, thus making it harder and harder for them to continue their feats. Peter Lynch was hardly alone in posting his best years early when he ran a much smaller Fidelity Magellan Fund. Another problem is that fund screens look for funds with low expenses but start-up funds tend to have artificially high expense ratios because initially there’s so little money to cover fixed costs. So how to uncover a new fund that’s likely to do well?

I look for a manager with a great track record either at a previous fund or in institutional investing. One great example last year was when David Winters, the well-regarded former chief investment officer of Franklin Mutual Advisers funds, opened his own fund, the Wintergreen Fund (WGRNX). My colleague Adrienne Carter profiled him in Business Week last month

With that in mind, I looked over a list of about a hundred new funds that opened last year, invest in domestic equities and have less than $150 million in assets under management. I then looked beyond the big fund shops and checked the managers listed for each remaining fund. There were some promising candidates. The downside, as I mentioned, is that the expense ratios tend to be high and some have front-end loads to get the attention of brokerage sales forces.

The first fund that caught my interest was the FBR Pegasus Fund (FBRPX), a new offering with a broad investing mandate from the fund arm of Friedman Billings Ramsey. This fund team includes David Ellison, a former Fidelity banking analyst, whose own small-cap financial fund beat 98% of its peers over the past five years (and beat the S&P 500 by 18 percentage points a year on average), according to Morningstar. Also on board are FBR’s other sector fund managers, like Winsor Aylesworth, whose technology and utility funds are both beating more than 60% of peers over the past three years. The top holdings at the end of 2005 were Sony ADRs, Shell ADRs and AT&T. Sweet - those three are up an average of 13% so far in 2006.

Next I came across the Keeley Midcap Value Fund (KMCVX) run by John Keeley, a value investor with 30 years of experience. His firm’s $1 billion small-cap value fund beat 94% of similar funds over the past 10 years and 98% over the past five, according to Morningstar. And he’s been running mid-cap portfolios for the wealthy for decades, beating the S&P Midcap 400 Index over the three, five and ten years before the new fund opened.

Finally, I’ve been intrigued by the utilities sector, which is out of favor because of rising interest rates but which also may benefit from easier regulations and increasing merger activity. The Reaves Select Research Fund (RSRAX) specializes in the utility sector. The fund’s the team of managers from W.H. Reaves & Co in New Jersey had outperformed the S&P Utilities Index in their private accounts over the past one, five, ten, 15 and 20 years.

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