Micro-Cap Funds Can Smooth Out Returns

NEW YORK (TheStreet) -- Micro-cap stocks have taken investors on a rough ride. In 2008, the Morgan Stanley Capital International U.S. Micro Cap Index dropped 44%, lagging the S&P 500 Index by 6 percentage points. The index has recovered this year, rising 38% and outpacing the S&P 500 by more than 25 percentage points.

The recent performance highlighted the appeal of these stocks, the smallest of the market. Although they can be extremely volatile, micro caps have outperformed the S&P 500 over long periods. During the 35 years ending in June, micro caps returned 14% annually, while large stocks returned 9.6%, according to Merrill Lynch, a unit of Bank of America(BAC Quote).

Micro-cap stocks can help diversify portfolios because they don't always move in lockstep with the S&P 500. Adding a mutual fund that owns a mix of small and large stocks might help smooth out long-term results.

To appreciate the strengths and weaknesses of micro caps, consider the performance of the Wasatch Micro Cap Fund(WMICX Quote), which has soared in good years and collapsed in bad periods.

During the downturn that began in 2000, the fund shined. At the time, investors were dumping large technology stocks and shifting to small value names. With money gushing into micro caps, Wasatch returned 50% in 2001, outdoing the S&P 500 by 61 percentage points, according to Morningstar(MORN Quote).

During the disastrous year of 2008, Wasatch lost 49%, trailing the S&P 500 by 12 points. For all the ups and downs, the fund boasts a strong long-term record, returning 12.0% annually during the past decade, outdoing the S&P 500 by 13 percentage points.