Five Funds: Small Growth Funds With Supersized Returns

Small things have a way of overmastering the great. -- Sonya Levien

Here are three reasons why investors should be looking into small-cap growth funds right now.

Reason #1: The Short Term. In 2002, the small-cap growth sector performed horribly. The average small growth fund lost 28.4%. If you believe stocks are slowly emerging from the brutal bear market, then small-cap growth may be in pole position to recover. In the 15 months after the 1973-74 bear market, the small-cap growth arena returned 45.2% -- outperforming small-cap value and large-cap stocks by seven percentage points, according to Ibbotson Associates. Small-cap growth also outpaced the rest of the market during the five months after the 1982 bottom and the 12 months after the 1990 bottom.

Reason #2: The Long Term. Small-cap stocks outperform. Period. From 1926 to 2002, large-cap stocks had a compound annual return of 10.2%; small-caps returned 12.1%, according to Ibbotson. And because they spent most of the 1990s lagging large-caps -- small-caps have never underperformed as much as they did at decade's end -- the category should get some extra juice from reversion to historical norms.

"We expect small- and mid-cap stocks will continue to rebound and will revert to their long-term premiums against large-cap stocks," said James O'Shaughnessy of Bear Stearns Asset Management. "Our forecast for the real rate of return to small- and mid-cap stocks through 2022 is 7% to 11% a year." He expects the S&P 500 to return between 3% and 5% during that period.

Reason #3: Diversification. Many investors still have too much large-cap in their portfolios, and that's exactly the place you don't want to be overexposed. A generous helping of small- and mid-cap stocks, both growth and value variety, will help you achieve the right balance. O'Shaughnessy suggests investors should have at least 15% of their total portfolio in smaller-cap stocks -- a little more for long-term investors who seek higher returns. Take a look at your quarterly statement: Do you have enough small-cap in your diet?

That's the focus of this week's Five Funds. Earlier we discussed small-cap value funds. This week we've unearthed five sound small growth funds that have notched stellar performance with steady hands at the wheel.