Maybe you could help me with this decision. My 401(k) will make available a small-cap index fund that mimics the Russell 2000 index. I heard you say that indexing is a good way to invest in 401(k) plans. Do you think the small-cap index fund would be a decent choice? It is the only small-cap fund open for consideration. -- Nancy Lingenfelter

A guy with 10 restaurants and a great fried chicken recipe won't get much attention from the financial community. But find his company before everyone on Wall Street does, and you could make a killing.

That's just one of the reasons that actual stock picking tends to work better than indexing in the small-cap world. This corner of the market still has enough great, undiscovered companies that it's possible for an enterprising money manager to do more than just match an index.

"To beat the index you have to do something different -- buy companies that aren't in the index, or weight the sectors and companies differently," says Bryan Olson, vice president at the Charles Schwab Center for Investment Research. "There's much more room to do that in the small-cap market."

In this country, outside of the 500 largest stocks, you've got at least 5,000 issues to choose from. And many of these companies are not widely followed by financial professionals. "By going out there, doing the homework and kicking the tires, small-cap managers are able to add more value," says Olson. More value should translate into index-beating returns, provided that a manager can keep trading and other investment costs to a minimum.

Those abundant opportunities arguably don't exist in the large-cap market. There, you've got thousands of money managers, analysts and reporters constantly combing over the same 200 stocks. That doesn't mean a stock picker who is buying large-caps can't beat the S&P 500, but it's a lot harder to do.

The data definitely back up this theory. Looking at five-year annualized performance ending Dec. 31, 70% of actively managed small-cap funds outperformed the Russell 2000 index, according to Morningstar. Over 10 years, 61% of small-cap funds beat that index.

Not So, Large-Caps

The exact opposite was true for large-cap funds. The S&P 500 index outpaced 72% of actively managed large-cap funds, based on five-year annualized performance.

What does this tell you? You're probably better off buying a solid small-cap fund run by a manager than putting your money in an index fund that tracks the Russell 2000 or another small-cap index. You have a fairly good chance of getting performance that's better than the index.

With large-cap stocks, you're going to have a much tougher time finding a manager who can consistently beat the S&P 500 over a long period of time. Thankfully, managers like Legg Mason's Bill Miller do exist. But they are few and far between.

You might hear this phenomenon described as the difference between an efficient and inefficient market. Here's the reasoning: Indexing works the best in markets where there's enormous attention paid to each stock -- such as the large-cap market in the U.S. There are so many participants in this market that prices rapidly reflect any available information, making it harder for stock pickers to gain any edge.

Rebalancing

Small-cap managers also have an advantage over small-cap index funds because of the way the underlying indices are structured and changed. Take the Russell 2000, the best-known small-cap benchmark. This index rebalances in the middle of every year. And to make sure it remains a small-cap index, it has to dump stocks that have grown too big. Translation: A fund that tracks this index is forced to sell its winners every year. Moreover, that selling can generate capital gains that could be passed on to investors, and that could make small-cap index funds less tax-efficient than their large-cap counterparts.

On the flip side, a small-cap fund manager can hang on to a stock that's rising and capture a lot more upside. And when the IPO market is pumping out plenty of hot new stocks, small-cap managers can fuel their returns with these young companies, long before they're added to a small-cap index. These indices aren't updated often enough to keep up with new companies that are hitting the market. (Of course, the IPO market has been a desert for the past year or two.)

So if you have a choice, you should try to find a solid, actively managed small-cap fund. If you don't have one in your 401(k) plan, then go ahead with a small-cap index fund. An index fund is still a cheap and easy way to invest, and you won't have to worry about the manager leaving.

Plus, adding some small-cap exposure to your portfolio should give it some valuable ballast. "You get the higher return potential and the diversification benefit by adding small stocks into a mix of large," says Olson.

However, money professionals have debated whether indexing works at all. If you have an opinion, please send a comment to dagen.mcdowell@thestreet.com .
In keeping with TSC's editorial policy, Dagen McDowell doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Dagen welcomes your questions and comments, and invites you to send them to dagen.mcdowell@thestreet.com.

If you liked this article you might like

In Defense of Muni Bond Funds

In Defense of Muni Bond Funds

Muni Bond Funds That Work for You

Muni Bond Funds That Work for You

Muni Bonds: They're Not Just for Rich People Anymore

Muni Bonds: They're Not Just for Rich People Anymore

Insider Trading Is Easy -- So Is Getting Caught

Insider Trading Is Easy -- So Is Getting Caught