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The Best Little Funds No One Is Talking About

Grandeur Peak's actively managed funds offer superior returns without too much risk.

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Virtually every reader who has called or e-mailed me in the past two years has talked about one or more of the following: Vanguard, indexing, low costs or Standard & Poor’s 500-stock index.

Don’t get me wrong. Investing in low-cost index funds, such as those offered by Vanguard and others, is sober and sensible. But if you look hard enough, you can also find a handful of actively managed funds that will likely deliver index-beating returns without taking outsize risks. A mix of index and active funds is, in my view, the best choice for many investors.

SEE ALSO: Why Most Stocks Are Stinkers (and What You Can Do About It)

Looking for a terrific active fund? You’ll find a couple at Grandeur Peak Global, a fund boutique in Salt Lake City. I’ve written about this company twice before, in 2012 and 2015. My confidence in their funds has only increased over time.

Returns for its two oldest funds, Grandeur Peak International Opportunities (symbol GPIOX) and Grandeur Peak Global Opportunities (GPGIX), have been spectacular. Over the past five years, the international fund has outpaced the Russell Global Small Cap ex-U.S. index by an average of 5.7 percentage points a year, and the global fund has beaten the Russell Global Small Cap index by an average of 4.5 percentage points annually. (All returns in this article are through August 10.)

Keep risks low. It’s not rocket science to run a fund that makes big bucks in bull markets. So far this year, the winning play has been to load up on the big tech stocks, the so-called FAANG stocks: Facebook (FB) Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX) and Google’s parent, Alphabet (GOOGL). But, of course, what goes up often comes down, and I’d expect these stocks, and any fund that owns a ton of them, to get killed in the next bear market.

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What captures my attention is a fund that can make healthy gains in a bull market but still hold up relatively well in market declines. The oldest of the Grandeur Peak funds have only been around for six years, a period without a bear market. How well the funds, which invest in small and midsize companies, will hold up in a bear market is my one big concern.

But the funds’ standard deviations—a measure of how much a fund’s price bounces around from month to month—are quite encouraging. The five-year standard deviations of the Global and International Opportunities funds are between 4% and 7% lower than the readings for their Russell benchmarks. Plus, the two funds have been above-average performers in the few broad-market selloffs since their inception.

What does it take to achieve superior returns without too much risk? Here are five key ingredients as practiced by Grandeur Peak

Don’t manage too much money. When it comes to investing in small companies, boutique firms are more nimble than the major fund companies.

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Of Grandeur Peak’s seven funds, only two, Grandeur Peak Global Stalwarts (GGSOX) and Grandeur Peak International Stalwarts (GISOX), are open to new investors. The five closed funds, with $2.8 billion in combined assets, invest in small-cap and micro-cap companies in the U.S. and abroad. The Stalwarts funds, introduced in September 2015, have a total of only $900 million in assets and plan to close when combined assets reach $5 billion. With a mix of small- and mid-cap stocks, the funds have weighted market caps (share prices times shares outstanding, with bigger positions counting for more) of roughly $4 billion. Because they own mid caps—which, compared to small-cap stocks, present fewer undiscovered bargains—the Stalwarts funds probably won’t do quite as well as the closed funds. But I have little doubt that long-term returns will be superb.

Stay out of the crowd. It’s much easier for a good stock analyst to find bargains among small-cap stocks, especially those domiciled overseas, than to find hidden gems among large-cap U.S. stocks. Many large-cap stocks are covered by dozens of analysts; a host of small-cap stocks attract next to no coverage. “We’re looking for things in places no one else does,” says Randy Pearce, the firm’s chief investment officer and lead manager on both Stalwarts funds.

Hire a lot of good people… Grandeur Peak employs 24 analysts and portfolio managers. That’s a lot of talent to invest no more than $8 billion—a relatively small sum in mutual funds. “Are the big players going to staff a strategy with 24 people with an $8 billion capacity? I don’t think so,” Pearce says. Half of Grandeur’s hires worked previously at Wasatch, which invests similarly and boasts a solid long-term record, but, in my view, has grown too large to do as good a job as Grandeur Peak still can.

Grandeur Peak isn’t run by a star manager. Instead, six industry teams, each composed of three analysts and one manager, do most of the firm’s stock picking, dividing the world’s stocks by industry. On average, analysts make four or five trips overseas each year and visit dozens of companies. Detailed reports rank companies numerically in a number of categories, such as profit margins, sales and earnings growth and stock valuation.

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The idea is to come up with a lot of high-quality, mispriced stocks rather than load up on a handful of great stocks. The analysts collectively pick about 350 stocks that meet the firm’s criteria and make it into the company’s growth-oriented funds. The funds tend to favor technology, industrial and financial services companies. They underweight energy and typically own little if any basic materials, real estate and utilities stocks.

… and give them skin in the game. Grandeur Peak is owned by its three founders, and everyone at the firm has a financial stake in its success.

What’s more, the analysts and managers are rewarded for aiming high. Bonuses are based on one-, three- and five-year returns that are at least four percentage points above the benchmark index.

Charge what you’re worth. I gag at the expense ratios. The two Stalwarts funds charge 1.35% of assets annually. But as with buying anything, what’s important is what you get for your money. The closed funds, not surprisingly, charge even more.

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Now may be a particularly good time to buy the funds. No one––I mean no one––has gotten in touch with me recently looking for a high-priced, small-cap fund that invests most or all of its assets in foreign stocks. And that appeals to my contrarian nature because in investing, the crowd is usually wrong.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

SEE ALSO: 6 Index Funds That Are Cheaper than Vanguard