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What this year's top fund managers are doing to smoke the competition

Dion Rabouin
Stock pickers are getting their mojo back this year, as the best performing funds have feasted in market famine thanks to little-known healthcare and technology stocks.
Stock pickers are getting their mojo back this year, as the best performing funds have feasted in market famine thanks to little-known healthcare and technology stocks.

As big names like Facebook, Alphabet and General Electric have floundered, less popular names like Mulesoft (MULE), Vericel (VCEL) and Axon Enterprise (AAXN) have powered the year’s best performing funds.

After a strong start to the year on the back of a blockbuster 2017, U.S. stocks broadly settled into a malaise beginning on Feb. 1. The Nasdaq (^IXIC) and Russell 2000 (^RUT) have only edged into positive territory for 2018 after a recent hot streak, and the benchmark S&P 500 (^GSPC) remains negative along with the Dow (^DJI).

But some funds have managed to provide strong returns this year with the top performers owing much of their success to a heavy dose of outperformance from small-cap stocks and little-known equities in the technology and health care sectors.

“The economy has gotten better and the FAANGs have slowed down somewhat from their torrid pace of revenue growth a few years back,” said James L. Callinan, portfolio manager of the Osterweis Emerging Opportunity Fund, one of the 10 best-performing funds between Feb. 1 and May 7, when the market was in its doldrums. “The revenue growth from small cap companies that I invest in and peers that are leading the market are now starting to show relatively faster growth than their large cap brethren.”

February wasn’t bad for everyone

Of the top 10 returning stocks since Feb. 1, seven are small-cap funds. The small-cap funds also make up 19 of the top 25 best performing mutual funds, according to data from Thomson Reuters Lipper. That’s in stark contrast to the last few years when big companies, led by the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google parent company Alphabet) have delivered the lion’s share of gains for investors.

Feb. 1 is an important milestone because it marked a break between the strong melt-up in the equity market that had followed 2017’s banner returns and the more muted gains seen throughout the rest of this year. From the beginning of the year to Jan. 31 the S&P 500 had rallied 6.6%. The Nasdaq gained 8% during the same period. But those gains flamed out as market sentiment shifted following a strong January U.S. jobs report that suggested the Federal Reserve could quicken its pace of interest rate increases. Then came concerns about online privacy, the flaring of trade tensions between the U.S. and China and the 10-year Treasury note yield rising to 3%.

Since Feb. 1 the S&P has fallen by as much as 6.7%, with the Nasdaq off 8.6% and the small-cap Russell 2000 falling 7.4% to its lows of the year. All three indexes have largely rebounded but have only recently moved into positive territory for the year, excluding the S&P, which remains negative for 2018.

Callinan points to specialized online lending company Enova (ENVA) and other companies in the consumer lending space such as Lending Tree that have stepped into a void left by many local banks. The local financial institutions have cut back lending to individuals as a result of regulations like the Dodd-Frank Wall Street Reform and Consumer Protection Act, he says, and that’s allowed companies like Enova to step in and reap big gains.

The tech boom you haven’t heard about

Highland Capital Management President Jim Dondero, who manages the firm’s small cap equity fund, said investment in biotech and restructuring companies, such as MPM Holdings (formerly Momentive) and Vistra Energy (formerly TCEH Corp.) have been key to his fund outperforming the market as one of the 10 top performers.

“The portfolio is overweight innovative biotech companies that we don’t believe will be negatively impacted by healthcare reform,” Dondero said. “The fund also has a number of restructured equities — opportunities we identified via our extensive activity in credit — that have contributed to year-to-date performance.”

Technology is a major theme among the top-performing funds, but it’s been little-known names such as cloud computing company Nutanix and software application integrator Mulesoft, which was recently acquired by Salesforce, that have driven major gains for shareholders, fund managers say.

Christopher Devlin, portfolio manager of the Selective Opportunity Fund, which gained 15.3% during the market’s malaise period and is up 21.1% year-to-date, called Mulesoft the “primary driver of performance” in his fund this year.

The volatile market this year has so far benefitted stock pickers, as the small-cap success has not been broad based. A recent Bank of America-Merrill Lynch study found that small cap funds posted their third consecutive below-50% monthly hit rate, with just 37% of managers outperforming the index year-to-date. That’s well below the rate for mid-cap (54%) and large-cap, where six out of ten managers outperformed in April and for the year.

Holding lots of cash

Despite running the second-best returning fund in the country, Devlin says he’s not particularly bullish on the overall market going forward and has been “cautious for two or three years.”

“We do think the market is relatively expensive right now, so we’re cautious,” he said. “We’re actually positioned with about 40% cash at the moment. We’re really ready for a downturn of some type.”

Holding cash is surprisingly common amongst the top-performing funds. Five of Lipper’s 10 top funds have more than 5% holdings in cash, according to Morningstar data, and three are holding more than 20% of their portfolio in cash.

Aram Green, who manages ClearBridge’s Select Fund and Small Cap Growth Fund, both among the 10 top performers, had been holding 20% of the portfolio in dry powder earlier this year. He has recently cut back his holdings of cash as he’s found some opportunities in the market.

“The market has rewarded innovators this year,” Green said. “A lot of things that did work last year have just petered out … Having exposure to the winners and lack of exposure to companies that are hurting from sector rotation is why I think the strategies have done well.”

The No. 1 fund this year has been the Perkins Discovery Fund, run by a father-son duo out of Wayzata, Minnesota, “on the shores of Lake Minnetonka.” Led by AxoGen (AXGN), a medical device manufacturer specializing in nerve repair, up 59% year-to-date, and Vericel, a cell therapy product marketing company, up 127% this year, the fund has gotten a major boon from healthcare stocks. It’s up 22% so far this year. The fund does carry a hefty 2.4% expense ratio.

Healthcare was the top sector holding for four of the top 10 funds, according to Morningstar, and was one of the top two sector holdings for eight of the top 10. Tech was the other major holding, representing the top sector for the six remaining top 10 performers, and a top two sector holding in all 10.

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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