When most people think about small cap mutual funds, the music from the Twilight Zone starts to play in the back of their mind. They know that small cap funds are an important investment management strategy, something that needs to find a place (even a small place in percentage terms) in their asset allocation model, but this part of portfolio building is arguably one of the toughest (next of course to specialty funds). I am also one of those apprehensive investors when it comes to Small Cap Funds. So let’s examine why they are so scary. Ultimately, what makes small cap funds a scary, dark corner is their underlying assets, which are small cap stocks.

…what makes small cap funds such a scary, dark corner is their underlying assets…

And those stocks, thanks to the credit crisis that began in 2007, have become under-capitalized (it has been tough enough for big, AA-rated corporations to secured funding), profit-margin pressured (the big guys need to survive, the small guys need to make money), quarterly, trailing losses (price cutting to compete for smaller opportunities means losses), and we could spend a whole page rhyming off what makes so many small cap so darn scary. But perhaps the next paragraph will really hammer home the reality about this niche category.

One more thing worth noting is that so many small caps are now officially “bankrupt,” meaning they owe more than they own thanks to the list noted above, plus the sharp decline in demand for their products over the past two yeas. This not only makes small caps a really scary place to invest, but it leaves the investor waiting at the edge of their seat for each quarterly announcement. Will this bankrupt company finally start making money or will this be the quarter that gets their bank line yanked, stripping them from any source of capital and forcing them to shutter up? Those fears are very real and they are a lot more common in small caps than any other segment.

So where does that leave investors? How can one pick a small cap mutual fund that will not get hammered by failures?

The first place to start is the underlying assets. While this is important when investigating all mutual funds, it is particularly important when sifting through potential small cap investments. Why? Because if those underlying assets are at risk (such as some housing stocks, some small-cap biotech, some small-cap alternate energy, resources, etc., etc., etc., etc., you get the point) then the fund’s risk profile will skyrocket as well.

You need to know what those underlying assets are!

This then begs the question: what sectors are more apt to prosper in times of economic recovery? We already looked at small cap mutual funds that invest in housing and discussed how this sector can be profitable but also involves some risk. And we already looked at a Dryden Fund that invested in financial services, a segment, we believe, that stands to benefit from financial services reform.

Now if we take a step back and explore what needs to happen for housing to recover the way some of these housing-heavy mutual funds need them to, what needs to happen? Of course, lenders need to start spending money. Some government officials (namely the President) have expressed a demanding sense of urgency in getting big banks to lend more (while simultaneously increasing reserves and adopting safer lending practices, which is the finest example of a paradox to be uttered). But before those big banks start screwing up again, what really needs to happen?

Regional banks and other financial institutions needs to start lending again. And not big-time lending; we are talking about safe, retail lending, the kind that really depends on capacity to repay and borrower creditworthiness. We firmly believe that regional banks can get this right, they can control their lending practices and they can have a solid impact on economic recovery, the kind that will help those home builders and individuals alike. And solid impacts are important; without them, we have superficial growth aka stimulus that dries up once the funding is spent.

One fund that has all of the right underlying assets is the Ivy Small Cap Value fund. The bulk of their holdings (a staggering +34%) is in financial services assets. Companies like East West Bancorp, IBERIABANK Corporation and Wintrust Financial are included in their Top 10 holdings (note: all three of these financial services companies also pay dividends with the fund’s dividend yield at 2.8%, another bonus: see also Why Dividend Funds Can Take You From Zero to Hero….). While this is a strong weighting in an area that the Mutual Fund Site believes will be instrumental in economic recovery, consider that there are only 77 holdings in the fund. This allows for tighter management, which we believe is necessary when you have such a heavy weighting in one given sector.

Ivy Small Cap Value is considered a LOW RISK small cap mutual fund with ABOVE AVERAGE returns, the perfect recipe for long-term capital appreciation. This speaks to the skill of the fund’s management team, led by Timothy Miller since 2008.

Ivy Small Cap Value is a no brainer

But the numbers here are what impresses us the most. Average Price-to-Earnings is an attractive 15.7. Price-to-Sales is 0.4 while price-to-sales-growth is 7.5. And we already discussed that pretty little dividend yield of 2.8%. This becomes a no brainer. Plain and simple. Low risk, properly priced assets, and tremendous future growth potential all highlight just how well this small cap mutual fund can perform.

The risks with this fund lie in its heavy financial services weighting. While is offset to a large extent by its Industrial Materials and Consumer Services weightings, we believe that if financials disappoint, then Consumer Services probably will not be far behind. Notwithstanding this, Ivy Small Cap Value has outshone the category and benchmark while minimizing risk and, more importantly, picking up assets at great prices

Even with its relatively high Expense Ratio of 1.42%, the Mutual Fund Site has chosen the Ivy Small Cap Value fund as its top Small Cap Mutual Fund pick of 2010. An easy decision, actually, once all of the other small cap mutual funds were cut from the short-list.