Fund name: Westcore Micro-Cap Opportunity Fund (WTMIX)

Objective: The fund seeks capital appreciation by investing, primarily, in the "common stock of micro-cap companies that appear to be undervalued." The fund is primarily driven by quantitative models. For their purposes, micro caps are stocks similar in size to those in the Russell Microcap index. Those stocks range between $4 million and $1.7 billion in capitalization and all are traded on major exchanges; that is, they exclude "pink sheet" and over-the-counter stocks. Westcore intends to focus on companies below $500 million. They have the opportunity for limited investment in non-U.S. micro caps.

Adviser: Denver Investment Advisers. DIA is an institutional money manager founded in 1958, with about $9 billion in assets under management. They also manage the 11 Westcore funds, each of which is modeled after one of their institutional account styles. The firm employs 40 managers and analysts who work in a series of style-based investment teams (e.g., the small-cap value team). On average, the members of those teams have worked together for nine years. Eight of the equity teams have performance records of five or more years. Three quarters have beaten their benchmarks over the past five years, and six of the seven teams with 10-year records have done so.

Manager: Kris Herrick, Paul Kuppinger and Jon Tesseo. Mr. Herrick is one of the firm’s Managing Partners and the Director of Value Research. He’s been with the firm since 2000 and was, before that, an analyst at Jurika and Voyles. He co-manages the Small Cap Value and Small Cap Opportunity funds. Mr. Kuppinger is a Vice President with 18 years of investment experience. He joined the firm in 2006. Mr. Tesseo joined the firm in 2008 as a quantitative analyst. Before joining DIA, he served as a portfolio manager and/or a research analyst at OmniWealth Limited, Oak Research, Harris Investment Management (the Oakmark folks) and Navellier & Associates (with runs very growth-y Navellier funds). He’s been in the business for 20 years.

 Management’s Stake in the Fund: None yet reported, though Mr. Herrick does have substantial investments in each of the other four funds that he co-manages. In addition, DIA is entirely employee-owned and most members of the funds’ board of directors have investments in excess of $100,000.

Opening date: June 23 2008.

Minimum investment: $2,500 for regular accounts, $1000 for IRAs, UTMAs and accounts with an automatic investing plan.

Expense ratio: 1.30% after waivers. There is, in addition, a 2% redemption fee on shares held fewer than 90 days.

Comments: The folks at Westcore argue that you should have a substantial microcap component to your portfolio and you should trust them to be the folks who manage it for you. They make entirely reasonable arguments on both counts.

The argument in favor of micro caps is long-established. The research which is cited to support the so-called "small cap effect" is actually research which mostly supports a "microcap effect." The small cap effect is the tendency, over long periods, for the small cap stock universe to outperform large cap stock universe by about 1-2% per year. According to Westcore’s research, over the past two decades, an investment in micro caps would have returned 14.4% per year while the S&P500 returned 13.1% and the small cap Russell 2000 index made 12.8%. For ultra-small caps, though, the advantage is far larger. From 1927 through 2001, a portfolio comprised of the smallest 10% of all publicly-traded companies returned 20% per year while one invested in the largest 10% returned about half as much.

Because these stocks are driven by forces somewhat disconnected from those that drive very large caps, they tend to be weakly correlated with large caps. That means adding micro caps to a conventional portfolio makes a positive contribution to its risk-reward balance (that is, its efficient frontier). At almost any level of risk, adding a small allocation to micro caps boosts returns. Conversely, the presence of micro caps allows you to achieve almost any level of returns with decreased risk.

The argument for making that allocation now is straightforward, though scary. The stock market tends to rally about six months ahead of the end of a recession. In that rally, small caps tend to lead large caps and micro-caps tend to lead small caps. Micro caps have been through a weak period in the past three years (they trail the small cap index by about 4% per year), which has allowed their stock valuations to improve substantially.

The argument in favor of Westcore is pretty straightforward. The managers are experienced and, in particular, experienced in small and microcap investing, at Westcore and with a number of other families (Jurika & Voyles, Oakmark, and Navellier) that have a tradition of strong small cap funds. This fund was launched in response to institutional investor interest in the strategy, following DFA’s decision to close its U.S. Micro Cap I (DFSCX) fund. Because the strategy needs to appeal to institutional investors – pension funds and such – who as a group really dislike unpredictable returns and high volatility, the fund is designed to carefully control risk. Each of the 15 sectors that it tracks has a custom-designed quant screen to identify the most attractive stocks in its industry, but the fund as a whole will remain sector-neutral to the Russell index. That way they avoid the prospect of inadvertent overweights and the risk of getting pummeled when a single, favored sector implodes (see the general topic "Investing in financials" for further details). Finally, the fund has one of the lowest expense ratios of any retail microcap offering (there are only five cheaper, open funds among the 40 retail microcap funds) and the managers are comfortable with the prospect of closing the fund at $400 million in order to preserve its flexibility.

Bottom Line: This fund will, in all likelihood, be a solid citizen in the micro-cap world. Both the record of Westcore’s other funds and the advisor’s concern for its institutional clients suggests that it will provide solid rather than spectacular returns. The fact that the fund is team-managed, and that the team is experienced and risk-conscious all add to its appeal.