NEW YORK ( TheStreet) -- Small stocks were clobbered during the volatile markets of last year. In the third quarter, small blend funds lost 21%, according to Morningstar. For 2011, the funds lost 4.1%, trailing the S&P 500 by 6 percentage points.
Investors should not be surprised by the turbulent performance of small-cap funds. Many academic studies have shown that small-cap funds can be more volatile than large stocks. During rough times panicked investors can suddenly dump little-known small stocks and take refuge in giant blue chips, which seem like safer bets.
Although they come with risk, small stocks belong in nearly every portfolio because they can deliver strong long-term returns. Small-cap funds have ranked as one of the top-performing categories in recent years. During the past 10 years, small value funds returned 7.7% annually, outdoing the S&P 500 by four percentage points.
To find steady small-cap choices, I searched for funds that had outperformed their categories while taking only moderate risks. I started by screening for funds with strong five-year records. To avoid risky choices, I looked for funds with below-average volatility, as indicated by standard deviation, a measure of how much an investment bounces up and down. The winning funds include Hancock Horizon Burkenroad Small Cap (HHBUX), RS Select Growth (RSDGX) and Tocqueville Opportunity (TOPPX).
Among the strongest performers last year was RS Select, which returned 5.3%. During the past five years, the fund has returned 7.3% annually, outdoing 97% of funds in the small growth category. The RS managers prefer companies with track records for delivering consistent growth and rich profit margins. The managers aim to buy stocks that can continue growing for the next three years because of clear competitive advantages. Portfolio manager Melissa Chadwick-Dunn says that many of the fund's stocks proved resilient during the rough markets of last year. "We have leading companies that people want to own during flights to quality," she says. A holding is Align Technology (ALGN), which makes clear dental braces. The company is gaining market share because teenagers and adults prefer Align's products instead of the unsightly wires and brackets of traditional braces. The company's sales increased 38% in the most recent quarter. "Align is an industry leader with strong intellectual property and a competitive advantage," says Chadwick-Dunn.