Gains Great, Less Volatility

Smaller-cap stocks produce enticing returns, but most investors lack the fortitude to endure the volatility in this asset class. Neuberger Berman Genesis (NBGNX) specializes in small- and mid-cap growth stocks, but its seasoned management selects stocks that incur roughly the same amount of volatility as the broad market. Although risk-reduction typically means investors must settle for lower returns, the fund consistently beats its category peers and the broader market over longer-term periods.

Such long-term success has naturally caused investors to pile into the fund, swelling its total assets to $11.2 billion. That’s an enormous amount of money for a fund specializing in smaller-cap stocks, so management has been forced to invest in larger-cap fare. This formerly small-cap pure play now allocates 58 percent of investable assets among mid-cap stocks and 37 percent among small-cap stocks.

Fund manager Judith Vale, who’s led the fund since 1994, surveys the small- and mid-cap universe for names that boast strong balance sheets with high returns on invested capital. In particular, she focuses on firms that generate high free cash flow, which enables them to weather difficult economic environments. Ever mindful of risk aversion, management recently tailored its security selection to a slower growth environment by turning away from more cyclical stocks.

The fund tends to overweight its allocation to the energy sector, which has been helpful during that sector’s bull run over the past decade. But that doesn’t mean management won’t roll back the fund’s exposure to this sector when they sense a macro-level shift. Although the energy sector represented the fund’s second-largest industry allocation at the end of the second quarter, management pared its exposure to this sector by nearly a quarter by the close of August. Among its concerns, management became worried that China’s efforts to cool its economy could weaken the country’s demand for coal, so they reduced the fund’s weighting in coal producers such as Alpha Natural Resources (NYSE: ANR).

The fund is currently overweight in the consumer defensive sector relative to its benchmark, and that exposure normally offsets some of the short-term volatility from its energy plays. Still, the fund experienced some recent disappointment with its holdings in for-profit education companies Strayer Education (NSDQ: STRA) and Capella Education Co. (NSDQ: CPLA). The stocks of for-profit education companies have been pummeled lately due to a possible change in regulations that could make it more difficult for their students to receive federal loans. However, the fund’s management believes that both stocks should rebound once these companies satisfy the government’s new criteria for eligibility in student loan programs.

The fund’s risk-averse approach to stock selection and industry allocation means that Neuberger Berman Genesis tends to lag its benchmark Russell 2000 index during bullish periods. But the fund tends to outperform its benchmark during downturns when investors shift their portfolios toward stronger companies with less volatility.

Despite the treacherous bear markets over the past decade, the fund still managed to trounce both its benchmark and the S&P 500 on a total return basis over the five-, 10- and 15-year trailing periods. It gained 11.2 percent annualized over the 15-year trailing time period, compared to 5.5 percent for the broad market.

Overall, the fund’s portfolio has incurred significantly less risk than its benchmark, while keeping its risk level at similar levels to the broad market. Management’s judicious use of risk enabled it to beat the S&P 500 by wide margins on a risk-adjusted basis.

Though the fund employs a risk-averse approach to stock picking, smaller-cap stocks can fall much harder than large-cap stocks during bear markets. Still, the fund’s largest rolling 12-month loss of 40.8 percent compares favorably to the S&P 500’s 43.3 percent loss. It’s impressive for a fund with a smaller-cap concentration to lose less than the S&P 500 during such a vicious bear market.

Management’s stock-picking prowess is also evidenced by its low portfolio turnover. In contrast to the more active trading of its category peers, the fund turns over a mere 9 percent of its portfolio annually.

With Neuberger Berman Genesis, investors can enjoy the outsized gains from small- and mid-cap stocks without the concomitant volatility.

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