Dear Dagen: Is Now the Time to Invest in Small-Cap Value Stocks?

Don't take sides in the eternal growth-vs.-value debate. When it comes to small-caps, own both.
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For the past few months or so, small-cap value has performed better than growth. Small-cap value also performed better in years like 1997. Where do you believe the better performance will be and why? -- Ron Dunn

Ron,

After playing towel boy for much of the 1990s, the small-cap market has rallied this year. But I wouldn't want to take sides in a match between small-cap value and small-cap growth.

If you think you have some special insight into this already opaque area of the market, good luck to you. But taking a strict approach to this sector could be especially perilous.

Yes, small-cap value has done particularly well over the past few months, in part related to a sector rotation to cyclical stocks. But growth is not far off. For the second quarter, the

Russell 2000 Value

index is up 15.8%, while the

Russell 2000 Growth

index climbed 14.6%.

Both numbers look pretty good, but there is a slight performance difference. And year to year, this disparity can be much more dramatic.

A random look at the 1990s bears this out. In 1992, small-cap growth underperformed small-cap value by more than 20 percentage points. But in 1995, the Russell 2000 Growth index returned 31% compared with 25.8% for the small-cap value index.

"Going forward we couldn't tell you which one is better over the long run," says Brad Lawson, a senior research analyst at

Frank Russell

, the firm that created the small-cap benchmark.

"There are certainly a lot of academic studies that say over the long term, small-cap value is the place to be," Lawson adds. But "our philosophy is that we don't believe that strongly that value vs. growth will outperform over the long run ... We invest in both."

Keep in mind, though, that the tendency of growth stocks to be more volatile than value stocks is magnified in the small-stock sector. "For one thing, the valuations tend to be high, so when things go wrong you have further to fall," Lawson says. You will often see a small-cap growth fund go from fabulous to forlorn in no time at all.

Remember

Garrett Van Wagoner's

performance in 1996? During its first five months of life (January through May 1996), his

(VWEGX)

Emerging Growth fund was up 56.6%, then fell 19% over the remainder of the year. The following year, the fund was down 20%.

That is one of the reasons you might have a hard time picking a small-cap growth fund. A fund racks up some hot numbers, the money floods in and then the manager has a hard time investing all the new cash in this narrow part of the market.

With funds, you may want to think about using a blend, one that combines elements of the growth and value styles. Or come up with your own combination of value and growth. Asset size is usually an issue when looking at small-cap funds. You should also examine the performance of the fund year over year to see how dramatic its swings are.

One small-cap fund with a good, long-term track record is the 29-year-old

(ACRNX) - Get Report

Acorn fund, a blend of growth and value, run by

Wanger Asset Management

. The fund has a median market cap of $1.2 billion, according to

Morningstar

. That's on the higher end of the small-cap spectrum. But its return has averaged 17.4% annually over the past five years.

If you want an index, look to

Vanguard's

(NAESX) - Get Report

Small Cap Index fund, which tracks the Russell 2000. (Vanguard also has funds that track the

Standard & Poor's SmallCap 600/BARRA Value

and

SmallCap 600/BARRA Growth

indices.) Some will argue against using an index in the small-cap category, that managers can add more value in this less-efficient and under-researched area of the market.

Or maybe you know about some fantastic undiscovered manager. If so, let me know. Email me at

deardagen@thestreet.com.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.

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