Could your portfolio use a little more pop?
If the answer is yes — and you have a long time horizon — then a small-cap fund may be a smart investment for you, says Mike Chadwick, a financial adviser in Unionville, Conn.
"Small-caps tend to be high-octane," Chadwick says. "They're up when things are going well, and when things get rocky they're the first to fall apart."
Small-cap funds invest in companies with market values from $300 million to $2 billion — businesses that are less mature than larger companies, with stocks that tend to be riskier. Earnings can be volatile, balance sheets may be fragile and their products or services may fail to catch on in the marketplace.
Over long periods, though, investors tend to be rewarded for this small-cap "risk premium." From 1926 through 2011, the largest 10% of companies returned an average 9% a year, while the smallest 10% returned 12.9%, according to the Center for Research in Security Prices and Ibbotson Associates.
Living in the shadows
One reason small caps may outperform over long stretches is that they're less scrutinized by Wall Street — creating more opportunities for their stocks to be mispriced. According to a recent study by investment advisory firm Punch & Associates, an average of 23 analysts covers each large-cap stock; the number is just six for small-caps.
"The small-cap area is the most inefficient part of the market," says Craig Hodges, co-manager of the Hodges Small Cap Fund (HDPSX).
Indeed, some studies show that active managers can add the most value in the small-cap space, outperforming the market more often than large-cap managers.
While small caps may eventually outperform, they can trail their larger siblings for long periods — as they did in the second half of the 1990s. Small caps also tend to tumble when the markets head south, notes Tom Roseen, head of research services at Lipper. Indeed, small-cap funds plunged 57.6% from October 2007 to March 2009, faring slightly worse than large-cap funds.
Another risk is valuations. Small-caps have soared since the market lows of 2009 and are now pricey by some measures: The Russell 2000 index (.RUT) trades at 18.5 times forward earnings compared to 15 for the large-cap S&P 500 index (.SPX). Moreover, most small caps pay little or nothing in dividends.
Ultimately, how much to invest comes down to your "stomach for volatility," says Roseen. Most advisers recommend small caps for around 10% of a stock portfolio, though you may want to invest more if you have a long time horizon and can handle short-term swings in the market.
To find compelling actively managed funds, we asked Lipper to screen for funds with three-year track records in the top 20% of their category. We also looked for consistent performance and screened out companies with front-end loads, excessive fees and minimum investments above $2,500.
While we've highlighted funds with strong records, these funds may not outperform in the future. Investors may want to ease into these funds gradually over time. We also encourage you to consider the funds in the context of your broader portfolio and take a careful look at any fund, including reading the prospectus, before investing.
Artisan Small Cap Fund
- Ticker: ARTSX
- 3-year average annual return: 23.8%
- Expense ratio: 1.53%
Based in Milwaukee, the managers of the Artisan Small Cap Fund (ARTSX) view themselves like farmers tilling and harvesting a wide array of stocks.
In the "garden" phase, they take small positions in businesses with attractive valuations, accelerating earnings and growth potential. If the business proves itself, the fund increases its position and a company moves into the "crop" category, says lead manager Craigh Cepukenas.
"We make all our mistakes in the garden," he says. "The crop is the punching power of the portfolio."
Focusing on growth companies, the fund holds roughly 65 stocks with an average market-cap of $2.5 billion. Its emphasis on larger companies has helped limit losses. Indeed the fund has lost 70% as much as the Russell 2000 Growth index (.RUO) in down markets over the past 3½ years, according to a report by Morningstar analyst Greg Carlson.
If there's a common theme it's "disruptive" businesses in industries with solid growth, says Cepukenas. A good example is Isis Pharmaceuticals (ISIS). An early-stage drug development company, Isis specializes in "antisense" technology which has the potential to create drugs inexpensively for a wide range of diseases, he says.
The downside: Technology stocks account for 43% of the fund's $1.2 billion in assets. That could hurt performance if other sectors outperform.
Hodges Small Cap Fund
- Ticker: HDPSX
- 3-year average annual return: 23.6%
- Expense ratio: 1.41%
While some funds concentrate on a handful of sectors, Hodges Small Cap Fund (HDPSX) invests more broadly. The portfolio includes everything from the United States Steel (X) to shoe retailer Shoe Carnival (SCVL) to ETF provider WisdomTree Investments (WETF).
"We get ideas from anywhere and everywhere," says Hodges, who is based in Dallas. "We'll look at basically any kind of company."
Holding roughly 80 stocks with an average market value of $1.3 billion, Hodges and his team seek companies that can benefit from internal growth and strong industry trends. A top-10 holding, for example, is Trinity Industries (TRN), which makes railroad cars for freight transportation and should benefit from higher rail usage and other factors, says Hodges.
The downside: While the fund captured 147% of the market's upside over the last five years, it captured 146% of the downside — meaning it could lose quite a bit more than the market in a downturn.
Glenmede Small Cap Equity Portfolio
- Ticker: GTCSX
- 3-year average annual return: 21.3%
- Expense ratio: 0.93%
Many of the 95 stocks in Glenmede Small Cap Equity Portfolio (GTCSX) are value plays: The fund's average P/E ratio is 14.5, well below the small-cap index average, according to Morningstar. And its stocks look cheap on other measures like price-to-book and price-to-sales.
Managers Christopher Colarik and Robert Mancuso look for companies they think have attractive valuations, positive earnings and sales momentum. They also invest thematically, looking for industry trends that can help firms grow faster than the broader economy.
Auto suppliers, for instance, are now benefiting from "pent-up" demand for new vehicles, says Colarik. Along those lines, the fund holds stakes in American Axle Manufacturing (AXL), emission-control business Tenneco (TEN) and car dealer Sonic Automotive (SAH).
The downside: Though it's not more volatile for its category, the fund has been about a third more volatile than the S&P 500, according to Morningstar.
Skyline Special Equities Portfolio
- Ticker: SKSEX
- 3-year average annual return: 22.5%
- Expense ratio: 1.33%
Skyline Special Equities (SKSEX) has trounced 98% of rivals over the last three years and may owe its success to a tough-love sell discipline.
Each of the fund's 69 stocks is reviewed frequently and if the managers wouldn't buy it at current prices, the stock is sold, says co-manager Michael Maloney. "We don't let our winners run," he says.
Based in Chicago, Maloney and his colleagues look for stocks trading at a discount of 20% or more to the market with potential for 10% to 20% earnings growth. These kinds of stocks are discounted for a reason: They're out of favor or neglected by Wall Street. But that's why they have so much upside potential, says Maloney.
The downside: The fund has had some rocky years, including 2008 when it plunged 40.1%, ranking in the bottom 9% of small-cap value funds, according to Morningstar.
Buffalo Emerging Opportunities Fund
- Ticker: BUFOX
- 3-year average annual return: 31.9%
- Expense ratio: 1.51%
Based outside Kansas City, Kan., Buffalo Emerging Opportunities (BUFOX) invests in the smallest, riskiest stocks. The fund's average market cap is just $659 million, less than half its benchmark index. And the fund only has $163 million in assets, making it the smallest of our picks.
While it's tricky territory to navigate, the managers do their best to find the sturdiest companies with the strongest growth prospects.
One way they reduce risk is by sticking with companies that have little or no debt and strong cash flows, says co-manager John Bichelmeyer. These types of businesses don't need much external financing to fund their growth, he explains, and they can generate strong returns since they're early-stage growth companies.
Bichelmeyer is now emphasizing technology stocks, which make up around 60% of the fund's assets. A top holding is SPS Commerce (SPSC), a software firm that helps manufacturers sell their products through retail stores. SPS's technology has "eaten the lunch" of rivals, he says, and the stock has surged 74% this year alone.
So far, the fund's performance has been strong. It beat 99% of small-growth funds over the last three- and five-year periods, according to Morningstar, and it ranks in the top 2% this year with a 35.1% return.
The downside: The fund's heavy tech weighting could be a drawback if the tech sector falters. The fund is more volatile than the average small-growth fund, according to Morningstar. It lost 48% in 2008, ranking in the bottom 8% of its category, though it's rebounded sharply since then.
Steve Garmhausen is a freelance contributor to Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.