Large-cap stocks make the headlines, but lately the small-caps have been making investors money.
Anyone considering how to invest for the long haul inevitably runs up against the
allocation question. Advisers agree that only a well-balanced mix of asset classes -- stocks and bonds, foreign and domestic, small-cap and large-cap -- will protect your portfolio in all kinds of weather. In coming weeks, this column will examine some of these issues.
So diversification is the traditional argument in favor of small-cap stocks. But a look at the market's recent history shows there's another one: Smaller stocks have just been doing better.
Small-cap value, blend and growth funds have returned an average of 15.3%, 12.7% and 3.3% annually over the past five years. That puts them well ahead of their their large-cap peers. In fact, the small-cap funds have beaten their rivals by 11.8, 13.6 and 8.6 percentage points respectively over that span.
Small-caps have continued to dominate the big guys this year, even as many analysts have been forecasting a rotation into large-caps in conjunction with economic expansion. The
iShares S&P SmallCap 600
exchange traded fund is up 11.2% this year, compared with a 2.6% gain for the
That's not to say large-caps won't have their day in the sun. Eventually the tide will turn back toward big stocks. Still, the disparity in performance numbers highlights the importance of diversification within the equity portion of an investor's asset allocation.
Michael Corbett, portfolio manager for the $187 million
Perritt Micro Cap Opportunities fund, recommends that investors put 10% to 30% of their overall asset allocation into small-caps, depending on their risk tolerance and time horizon. Corbett says he expects small-cap companies to continue to outperform even after their recent run-up, mostly because of their ability to react quickly as the worldwide economy expands. Small companies can hire and fire faster and can ramp up production faster to meet increased demand.
Andrew Clark, strategist at
, agrees with Corbett's outlook and predicts that small-caps -- shares carrying a market value of $1.5 billion or less -- will finish the year ahead of large-caps for a fifth straight year. Clark adds that the
measured rate hikes are helping smaller companies that otherwise might have more trouble dealing with rising interest rates.
"The Fed is not moving too quickly, which helps small companies," says Clark. "The high cost of capital is tough for small funds to overcome."
Traditionally, investors maintain a 3-to-1 ratio of big-caps to small-caps. That means an investor with 45% of his portfolio in big-caps should have 15% in small-cap funds.
Most financial advisers put their clients in small-cap mutual funds instead of individual equities. That's due to two things: the sheer number of companies to choose from, and the higher risk in investing in some of these little-known names. There are close to 10,000 stocks in the small-cap universe, and most are relatively illiquid, with only a limited number of outstanding shares. This makes them far more volatile than their big-cap brethren. On account of this volatility, the average actively managed small-cap funds hold 182 stocks, according to Morningstar, compared with 112 for large-cap funds.
Todd Grady, analyst for the
Evergreen Special Values fund, says the added volatility in small-caps is also a function of their having fewer executives and narrower product lines. Unlike huge companies sporting deep managerial benches, small companies' decision-making power usually rests with only a handful of executives. Under these circumstances, strategic miscues or sudden declines in quarterly performance can exacerbate investor fears about management's capabilities, causing a sharp selloff in the stock.
While too much power at the top might scare investors, fund managers see the scaled-down executive roster as a benefit.
"The biggest joy in running a small-cap portfolio is in being able to talk to management," says Corbett. "I can regularly talk to the CEOs of companies I invest in, and that's something I can't do with big companies."
Investors in small-cap funds have expressed their joy over small-cap returns by funneling an overwhelming amount of new cash at the asset class, leading to a rash of fund closings. According to Morningstar, small-caps accounted for 24 of the 58 funds that were closed to new investors from January to August of this year. Small-cap fund managers have a particularly difficult time putting new money to work in a sea of illiquid names, which is why Lipper's Clark suggests investors look for funds that hold less than $1 billion in assets.
Financial advisers like Michael Kabarec, of Illinois-based Kabarec Financial Advisors, say they appreciate it when funds are responsible enough to close instead of risking shareholder performance. However, Kabarec says the stiff competition to get his clients into top small-cap funds forces him to maintain backup plans just in case his top-choice stops accepting new investors. For example, Kabarec switched to the
Royce Low-Priced Stock fund for new customers after favorite his small-cap fund,
Wasatch Small Cap Growth, closed earlier this year.
The rash of fund closings has gotten so bad that Morningstar has been left without a recommendation in the small-cap value category since the
FPA Capital fund closed this summer.
Of course, it's not easy for fund companies to close funds in the face of huge investor demand, which is why they are opening windows to new funds even as they are closing the doors on others. Fund giant Fidelity, for example, further closed its massive $31 billion
Fidelity Low-Priced Stock fund this summer even as it rolled out plans to add a pair of new small-cap funds in November, raising its selection of small-cap offerings to six.
John Sweeney, a product manager at fund giant Fidelity, says the introduction of two new small-cap funds -- a growth and a value fund -- comes in response to growing customer demand for greater specificity.
The huge demand for small-cap funds looks like a contrary indicator by market-watchers like Morningstar analyst Kerry O'Boyle, who says, "it's tough to pound the table on small-caps after the huge run-up they have enjoyed the past five years."
But even if the small-cap rally is growing long in the tooth, financial advisers like Brent Brodeski of Savant Capital Management in Illinois say small-caps are a vital part of their diversification plans.
"Usually people have little to no small-cap exposure when they come in, so we have to show them the value in small-cap funds," says Brodeski. "People are more familiar with large companies because they read about them in the papers, but that does not necessarily make them better."