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By Murray Coleman

It was just five years ago that micro-cap stocks were soaring to new heights. But now, as big blue chip companies return to favor, the tiniest of the small-cap universe remain near the bottom of most stock fund categories.

That includes a once-high flying Bridgeway Ultra-Small Company Market Fund [BRSIX]. As the grand-daddy of indexed micro-caps, the mutual fund has lost more than 8% so far this year. To put that into perspective, the exchange-traded fund iShares Russell 2000 Index (NYSEARCA:IWM) is down 2.7% in 2008. (It's also considered a small-cap blend fund, although the $9.1 billion IWM has a market cap roughly three-times BRSIX's size).

The Bridgeway fund isn't alone. Three ETFs that also follow micro-cap benchmarks are also badly underperforming their small-cap peers. Those are: iShares Russell Microcap Index (NYSEARCA:IWC); First Trust Dow Jones Select MicroCap ETF (NYSEARCA:FDM); and PowerShares Zacks Micro Cap ETF (NYSEARCA:PZI) (see chart below).

Still, micro caps remain a favorite with many long-term investors. BRSIX's assets top $862.7 million, not a small sum for a portfolio with a median market cap of $193 million. And BRSIX's almost double the size now as it was when Bridgeway had to close the fund for two years starting in 2003.

A Time Of Change

In 2004, micro-caps were still in the spotlight. BRSIX sat at the top of the heap with a three-year average annualized return of better-than 32%. That came on the back of a 24% gain in 2001 and 4.9% in 2002.

By the end of 2003, the index fund soared to return 79.4%, marking a stunning run of outperformance through the worst of the tech wreck and the subsequent surging bull market.

As cycles have cooled, BRSIX has slowed even more dramatically. In 2004, it fell to a middling performer. And after back-to-back years in the top 2% of its small-cap class, the micro-cap portfolio faded in less than a year to fall into the bottom 20-30% in subsequent years, according to Morningstar data.

Such a turnaround shouldn't be all that surprising, though. In strong small-cap dominated cycles, it's not unusual for the smallest of the small to shoot up more than their larger rivals. When conditions weaken, micro-caps tend to underperform. And sometimes by large amounts.

So why even bother with such a volatile part of the market? Over longer periods, the category has proved to be an even higher flyer than regular small-caps. Just look at BRSIX. Over the past 10 years, despite its extreme highs and extreme lows, the fund's average annualized total return of 11.44% beats the broader market by a mile. For example, the Vanguard Total Stock Market Index Fund [VTSMX] is up an average 4.29% in that same period.

Perhaps even more telling, the Vanguard Small-Cap Index Fund [NAESX] has gained 6.21% in the past decade. That's almost half as much as BRISX's yearly average, even with about 10% of its portfolio invested in micro-cap stocks.

To be fair, NAESX has one of its category's highest market caps at around $1.4 billion. Stacked against a broader Morningstar small-cap benchmark, BRSIX's 10-year return is slightly more than 2 percentage points per year. But that index's performance doesn't count fees and other expenses.

Either way, patient investors with iron stomachs can expect to realize at least some enhanced performance results over time.

Zigging When Others Zag

Diversification is also another plus of the asset class. For example, look back 10 years ago. In 1998, the CRSP Micro Cap Index lost 7.9% while the broader stock market racked up 24% gains. Three years later, micro caps were up 34% compared to the Russell 3000's 11.5% decline. And two years later in 2003, the benchmark of the smallest domestic stocks by market cap size shot up more than 78% as the Russell 3000 jumped almost 50% less.

"Those differences are surprising considering that both indexes hold thousands of publicly traded U.S. companies. Generally, academics believe that in a broadly diversified portfolio, individual company risk is diversified away, leaving only market risk," noted Richard Ferri in his book "All About Asset Allocation."

Micro-cap portfolios break that mold, he wrote. "Micro-cap indexes have a unique risk factor above and beyond indexes of larger stocks than cannot be diversified away by adding more micro-caps," Ferri added.

A portfolio that has an overweighting of micro-cap stocks acts different from a broader one, he concluded. Over a 30-year period through 2004, Ferri found that a stock portfolio with 80% of its assets in a total stock market index and 20% in a micro-cap index would have increased returns from owning a purely TSM portfolio by 1.1 percent. Even more importantly, those returns would've come with only a small increase in risk.

The 3,000-plus micro-caps that trade actively in the U.S. only represent about 3% of the value of the entire market, Ferri says. "Accordingly, the performance of micro-cap stocks does not have a large impact on the performance of the broad market," he added. "Overweighting micro-cap stocks in a portfolio as a separate U.S. stock category has had diversification benefits in the past and may add diversification benefits in the future."

ETFs Provide More Choice

With the category in a slump, an adventurous contrarian considering adding a micro-cap fund will find a trio of newer and a bit lower-cost ETF options than BRSIX. (While Bridgeway came out in July 1997, the ETF versions all launched within a month of one another in the second-half of 2005).

The broadest-based portfolio is the iShares Russell Microcap Index, which has 1,300-plus stocks with $277.3 million in assets.

IWC's benchmark covers the smallest 1,000 stocks in the Russell 2000 index plus the next 1,000 companies below it. The Russell micro-cap ETF includes companies with market caps ranging from about $55 million to $500 million. It uses a sampling technique so it doesn't hold the full 2,000 names possible.

The pair of other micro-cap ETFs use more active, though different, quantitative stock screening methodologies to outperform the market.

One is the $96.2 million PowerShares Zacks portfolio. PZI's underlying index is monitored weekly, and index creator Zacks Investment Research determines the criteria for its weekly and quarterly reviews. The firm ranks companies based on relative value and momentum characteristics. It also uses a modified equal weighting system.

The $15.8 million First Trust ETF tracks an index developed by Dow Jones. The micro-cap universe is screened on a variety of different technical and fundamental factors to come up with FDM's holdings. Those include size, liquidity, profit margins, earnings momentum and historical returns. Like PZI, its portfolio is rebalanced quarterly.

Name of Fund

Symbol

Number of Stocks

Expense Ratio

Leading Sector

YTD Returns

12-Months

iShares Russell Microcap

IWC

1,385

0.60 %

Financials (23.5%)

-8.85%

-18.63%

First Trust DJ Select Micro

FDM

245

0.60%

Industrials (21.1%)

-5.30%

-14.70%

PowerShares Zacks Micro

PZI

400

0.60%

Financials (23.3%)

-9.56%

-23.50%

Bridgeway Ultra-Small Company

BRSIX

484

0.65%

Consumer Non-Cyclical (28%)

-8.10%

-14.68%

Source: Microcap Funds: Down but Not Out