The Small-Cap Mutual Funds to Own Now

In the early 1990s, Eugene Fama of the University of Chicago and Kenneth French of Dartmouth caused a stir with research on long-term stock performance.

Analyzing data back to 1926, the two academics concluded that small stocks had outdone large ones and value topped growth. Based on the findings, it appeared investors could beat the S&P 500 simply by holding small value stocks.

Those who acted on the research have not been disappointed. During the 15 years ending in December, small value funds returned 7.7% annually, more than 1 percentage point better than the S&P 500, according to Morningstar.

The results may encourage investors to overweight small value now. But that could be a mistake. Having outperformed in recent years, small caps are not cheap compared to large caps. The price-to-earnings ratio of small value funds is 11.1, compared with 10.5 for large value.

In addition, small stocks can be volatile, sometimes recording steep falls. To appreciate the hazards that today's markets could present, consider how small stocks performed during the Great Depression. In 1929, large caps dropped 8.4%, while small issues fell 51.4%, according to Ibbotson Associates. The next year, small stocks gave up another 38.2%, more than 14 percentage points worse than large caps. While small stocks of all kinds suffered, the damage was particularly severe for small value stocks, says Ben Inker, director of asset allocation for money manager GMO. "Many small value stocks are junky," says Inker. "In really bad economic times, they go bust in disproportionate numbers."