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Microcap Funds That Rocket During Rallies

NEW YORK ( TheStreet) -- Microcap stocks have lagged recently. During the past five years, iShares Russell Microcap Index ETF (IWC) has lost 1% of its value annually, trailing the S&P 500 Index by 3.6 percentage points.

Most of the poor performance can be traced to big losses that microcaps suffered during the recession. As the financial crisis began unfolding in the second half of 2007, tiny stocks were among the first to sink, and they dropped sharply throughout the market downturn of 2008.

While the definition of microcaps varies, many portfolio managers say that the group includes companies with market capitalizations of less than $500 million. In contrast, the average market value of stocks in the S&P 500 is $48 billion.

It is not unusual for microcaps to underperform in downturns. The tiny companies tend to be more volatile and less well-run than the blue chips. Microcaps often face big debt burdens. As a result, the group records more than its share of bankruptcies. When investors began fleeing risk during the recent market downturn, they dumped microcaps. Hedge funds that had to raise cash were among the big sellers.

Should you avoid microcap funds? Not necessarily. While microcaps are prone to big downturns and long periods of subpar performance, the stocks tend to compensate by excelling in bull markets and outperforming over the long term. During the past 85 years, microcaps have returned 12.3% annually, compared to 9.4% for large stocks, according to the University of Chicago's Center for Research in Security Prices. The data suggest that investors who want to use a microcap fund should be prepared to wait patiently through downturns and what could be prolonged periods of underperformance.

To own a fund that can knock the cover off the ball in a bull market, consider Wasatch Micro Cap Value (WAMVX), which has returned 5.3% annually during the past five years. After crashing in the downturn, the fund gained 70% in 2009, outpacing the S&P 500 by 43 percentage points for the year.

Portfolio manager Brian Bythrow is an opportunist, holding a mix of growth and value names. He classifies some of his holdings as fallen angels, growth stocks that have slipped because of temporary problems. Other favorites are value-priced stocks that are beginning to enter a growth phase. Bythrow prefers companies that move under the radar. Many holdings have little or no coverage by analysts.
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