Go small. That is the latest line from the mutual fund industry.
Fund firms are pushing small-stock mutual funds pretty hard these days. Their pitch: When big-stock funds finally cool off, funds that invest in small-capitalization stocks will give your portfolio a lot of oomph.
But should you swallow the seductive small-cap recommendation? While many fund managers agree that small stocks– defined as companies with market capitalizations of less than $1 billion–can sometimes outrun their counterparts, a growing body of evidence over the past few years suggests that they don’t necessarily do better than large caps in the long term.
Those whose studies appear to debunk the small-cap myth include Jeremy Siegel, a finance professor at the Wharton School of Business in Philadelphia.
Now two other studies have surfaced that side with Siegel. One big gun has been aimed by David Dreman, chairman of Dreman Value Management. In his new book, “Contrarian Investment Strategies: The Next Generation,” Dreman punches a hole through an oft-cited doctoral thesis prepared in the early 1980s by Rolf Banz at the University of Chicago. The Banz study concluded that small caps had steadily outperformed large caps from 1926 to 1979.
In his book, Dreman argues that the Banz thesis failed to take into account the illiquidity–or difficulty of trading–of the stock market in certain periods. As a result, while it appeared that small caps generated hefty gains, especially during the Great Depression of 1931 to 1935 and during World War II from 1941 to 1945, most investors couldn’t buy small-cap stocks during those times because there was little to no trading. Any small-cap rally that appeared to have occurred was thus overplayed, Dreman says.
Another study, conducted recently by Boston-based fund firm Quantitative Group of Funds, found that small caps underperformed mid-capitalization stocks over a 19-year duration. Taking the 231 one-month periods from January 1979 to March 1998, Quantitative Group discovered that the small-cap Russell 2000 index posted losses in 86 months, with an average decline of 3.9 percent in those months. In contrast, during the same months the Russell Mid-Cap Index generated better returns 66 times, with an average decline of only 2.8 percent in down months.
“If people are looking to diversify from large caps, they should feel more comfortable with mid-cap funds” than small caps, says Robert von Pentz, a fund manager at Quantitative.
So where do all of these studies leave you and your portfolio? The new research should act as a cautionary tale, many financial planners say, and should stop investors from trying to pick the exact moment when to buy small-cap funds. But the studies shouldn’t put investors off purchasing small-cap funds entirely, they add. Small-cap stock funds can still spice up a portfolio, as well as help to spread out risk.
Consider some recent performance figures from Lipper Analytical Services Inc. Over the past five years through May 7, large-cap funds produced slightly more robust returns of an average 19.04 percent a year while small-cap stock funds generated 18.34 percent a year in the same period. Yet in the short term, small-cap funds were able to add pep to some portfolios: Lipper notes that in the 12 months ended May 7, small-cap stock funds gained 36.11 percent while large-cap funds achieved a 32.29 percent return.
“We include small-cap stock funds in virtually every portfolio we build, even for 85-year-olds,” says Bob Bingham, a principal at San Francisco investment advisory firm Bingham, Osborn & Scarborough. “I like both large-cap funds and small-cap funds because they’re uncorrelated to each other.”
Here are a few rough guidelines to help investors determine how appropriate small-cap stock funds are for their portfolios now:
– Just a slice. While small-cap stock funds will help balance out a portfolio that is heavy on large caps, financial planners urge investors not to embrace small-cap funds wholeheartedly, no matter how tempting the asset class appears. Small caps inevitably remain riskier investments, because the companies are less-seasoned than their mid-cap and large-cap counterparts.
Bingham suggests some approximate allocations: In a conservative portfolio, small-cap stock funds should form roughly a quarter of the total weighting, he says. Meanwhile, for a more aggressive investor, a weighting in small-cap funds can go as high as 40 percent of the portfolio, he says.
– Not all types. Don’t think that there is just a generic category of small-cap stock funds out there; plenty of different small-cap fund types exist. There are small-cap growth funds, small-cap value funds and micro-cap funds, which invest in tiny stocks with market capitalizations of less than $500 million.
High on fund manager and financial advisers’ lists right now are small-cap “value” funds, which purchase stocks of small companies that are perceived to be undervalued. Even Dreman, who is questioning the Banz study, reckons small-cap value funds are worth owning.
Unlike small-cap growth funds, which may invest in go-go momentum stocks such as technology startups, small-cap value funds tend to buy into underappreciated companies that toil away in less volatile industries such as banking. Because these stocks are already beaten down, they tend to suffer less during a market downturn.
