Who the Small-Cap Fits

Large-cap stocks make the headlines, but lately the small-caps have been making investors money.

Anyone considering how to invest for the long haul inevitably runs up against the allocation question. Advisers agree that only a well-balanced mix of asset classes -- stocks and bonds, foreign and domestic, small-cap and large-cap -- will protect your portfolio in all kinds of weather. In coming weeks, this column will examine some of these issues.

So diversification is the traditional argument in favor of small-cap stocks. But a look at the market's recent history shows there's another one: Smaller stocks have just been doing better.

Small-cap value, blend and growth funds have returned an average of 15.3%, 12.7% and 3.3% annually over the past five years. That puts them well ahead of their their large-cap peers. In fact, the small-cap funds have beaten their rivals by 11.8, 13.6 and 8.6 percentage points respectively over that span.

Small-caps have continued to dominate the big guys this year, even as many analysts have been forecasting a rotation into large-caps in conjunction with economic expansion. The iShares S&P SmallCap 600(IJR Quote) exchange traded fund is up 11.2% this year, compared with a 2.6% gain for the S&P 500.

That's not to say large-caps won't have their day in the sun. Eventually the tide will turn back toward big stocks. Still, the disparity in performance numbers highlights the importance of diversification within the equity portion of an investor's asset allocation.

Michael Corbett, portfolio manager for the $187 million (PRCGX Quote)Perritt Micro Cap Opportunities fund, recommends that investors put 10% to 30% of their overall asset allocation into small-caps, depending on their risk tolerance and time horizon. Corbett says he expects small-cap companies to continue to outperform even after their recent run-up, mostly because of their ability to react quickly as the worldwide economy expands. Small companies can hire and fire faster and can ramp up production faster to meet increased demand.