About a year ago, I looked at the performance of small-cap funds and compared it with S&P 500. The topic interested me because I am a fan of small-cap funds and have been buying them since I started investing in mutual funds. The last time when I checked the asset allocation of my portfolio, small-cap funds made up about 20% of my mutual fund investments. But that was after some big drop in small-cap fund performance, as I noted in my Is the Small-Cap Party Over? post last year, when small-cap lagged large-cap by a significant amount in short-term returns, as shown in the following plot.
Now, the financial market is still in a turmoil and the overall situation now is not better than one year ago. But small-cap funds have made a strong comeback lately, especially in the last three months, outperforming large-cap by a wide margin, as you can see from the comparison between Russell 2000 Index (^RUT) and S&P 500 Index (^GSPC) in the following chart.
An article from The Wall Street Journal yesterday summarized what have happened so far this year:
Year to date, the Russell 2000 has declined 6.2% and the Standard & Poor’s Small-Cap 600 index is down 4.5%. (There is no single definition of a small stock; one gauge is total stock market value or “capitalization” below $2 billion.)
By contrast, the Dow average and the Standard & Poor’s 500-stock index, two large-stock measures, are both down 15%. Since July 15, the Russell 2000 has surged 8.5%, compared with the Dow average’s 2.4% advance, as some investors have apparently started to position themselves for an eventual economic recovery.
According to the article, large-cap stocks generally perform better than small- and mid-size stocks leading to or in the early stage of the economic recovery. But the economy recovers, small stocks usually outperform large stocks: “in the 12-month periods following the end of the last nine recessions, small stocks on average provided a 24% gain, compared with 17.6% for the S&P 500.”
The performance of the Russell 2000 in the past six months is very impressive, but the question for investors are whether the recovery is indeed underway and whether it’s now time to add small-caps into portfolio to anticipate a strong return later. For one, the economy doesn’t seem to be in the recovery mode right now because the credit crunch shows no sign of easing and the housing market is yet to bottom. So it’s probably too early to load up small-cap stocks. If the financial crisis continues or become worse, small companies will suffer more than larger companies. But still, investors can use a diversified mutual fund portfolio with exposures in small-cap funds to explore the small stock opportunity. As suggested by the article:
For a relatively smooth ride, Morningstar analyst Marta Norton suggests looking at “small value” funds, which tend to be less volatile than “small growth” funds. The category’s 5% loss for the year to date, through Thursday, is better than any other diversified stock-fund category.
In addition to the traditional mutual funds, you can also find exchange-traded funds (ETFs) specializing in small-cap value investment (funds with YTD return):
iShares Russell 2000 Value Index (IWN): 1.31%
iShares S&P SmallCap 600 Index (IJR): -1.36%
Vanguard Small Cap Value ETF (VBR): -1.73%
iShares S&P SmallCap 600 Value Index (IJS): -1.03%
PowerShares Dynamic Small Cap Value (PWY): -0.25%
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