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TheStreet Open House

Small-Stock Mutual Funds Keep Growing

NEW YORK ( TheStreet ) -- Small growth stocks have climbed sharply lately, as have the mutual funds that invest in them.

The average small growth mutual fund returned 25.2% this year, compared to 17.8% for the S&P 500, according to Morningstar.

Despite concerns about the Federal Reserve's tapering plans, many small growth mutual funds have continued rallying in recent weeks. During the past month, Buffalo Emerging Opportunities (BUFOX) gained 2.0%, and MFS New Discovery (MNDAX) returned 2.8%. In contrast, the S&P 500 lost 2.2%.

A variety of factors are lifting small growth funds. For starters, the recovering economy is providing a special boost for small stocks. As investors gain more confidence that the economy can avoid recession, they are shifting to riskier small stocks that seem poised to increase sales.

In addition, the small stocks seem well positioned to survive the turbulence that could be caused by Federal Reserve's tapering program.

Faced with the prospect that the Fed could slow its bond purchases, investors have pulled out of emerging markets. That has slowed emerging economies and hurt multinational blue-chips that derive a big part of their sales from Asia and Latin America. But many small growth companies have avoided the damage because they serve only U.S. markets.

Concern about tapering has also hurt dividend-paying blue-chips. Investors figure that when the Fed stops buying securities, bond prices will fall and yields will rise. That will make bonds more attractive compared to dividend-paying stocks. But rising rates have done little to harm small growth stocks, since many do not pay dividends.

After their big rally, small growth stocks are no longer cheap. The average small growth fund's portfolio has a price-to-earnings ratio of 22, compared to 18 for the S&P 500. If the economy slips, small stocks could tank. Still, small growth stocks should continue leading the markets as long as the U.S. economy keeps plodding ahead.

To bet that the rally will continue, try Buffalo Emerging Opportunities. During the past five years, the fund returned 17.8% annually, outdoing 99% of peers.

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