Five Winning Funds: Big Bang From Small Companies

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

This week's Five Winning Funds turns its attention to small-cap growth funds. Here are three reasons why investors should be looking at these right now.

Reason No. 1: The Short Term. In 2002, the small-cap growth sector performed horribly. The average small growth fund lost 28.4%. They have posted a stark turnaround so far this year -- the average small growth fund is up 17.5% in 2003, according to Lipper, a Reuters company. If you believe stocks are emerging from the brutal bear market, then small-cap growth may be in the pole position. 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 7 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 No. 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.

Reason No. 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, will help you achieve the right balance. At least 15% of investors' total portfolio should be in smaller-cap stocks -- 30% to 35% is more like it for long-term investors who seek higher returns.

Before we get to some worthy funds within the category, a few quick general items about small-cap growth. As you might expect, these mutual funds hunt for companies with less than $1.5 billion or so in market capitalization that look poised to grow significantly. This is 10-bagger territory, but it's also loaded with pitfalls. Investors should seek out small-cap funds that have outstanding long-term performance with tenured managers.