Is the Small-Cap Party Over?

I am a big fan of small-cap funds. At one time, I had several small-cap funds, both value and growth, in my taxable investment accounts. Though I have trimmed the number to two, they are still a significant portion of my portfolio as small-cap is nearly a quarter of my taxable mutual fund investments.

The reason for having a large small-cap investments is quite simple: Historically, the return from small-cap investments is 2% higher than the return from large-cap stocks. Since the burst of tech bubble in 2001, small-cap stocks as a group have outperformed large-caps each and every year. The following is a chart comparing Russell 2000 (small-cap) and S&P 500 (large-cap) for the past five years. The superiority of the small-cap is evident.

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The argument for the better performance of the small-cap during the recovery from a recession is that small companies can response quickly for the change of market conditions. However, when the economy enters the normal growth mode, large companies have an edge over their small rivals because of the advantage of their ability to obtain capitals to sustain the growth.

It has been quite a well since some experts predicted that in the current economic cycle, the small-cap has run its course and it’s time for the large-cap to shine. After some delays, that prediction may finally come true. The following is the YTD performance comparison of Russell 2000 and S&P 500. What I saw from the chart is that every time the stocks dropped, especially since the credit crisis began in July, the small-cap went down even further while the rebound wasn’t as strong as the large-cap has experienced. That’s understandable because during the credit crunch, small companies could feel more pain from the rising cost of credit.

rut_ytd.png

Year-to-date, S&P 500 has returned 9.03% while Russell 2007 has gained 5.60%. 2007 could be the first year in a while that the large-cap outperforms the small-cap. Does it signal that the small-cap party is finally over?

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14 Responses to “Is the Small-Cap Party Over?”

  1. Moneymonk |  Oct 03, 2007 at 12:19 pm

    Not neccessarily, I love small cap funds also, not only for diversification but for growth. Like other funds it has it ups and downs. I just think it is a cycle they are going through and will come up again soon.

  2. The Dividend Guy |  Oct 03, 2007 at 6:29 pm

    I don’t think it is over – perhaps it is a buying opportunity?

  3. JC Carvill |  Oct 04, 2007 at 1:00 am

    One of the biggest advantages of investing in small-cap stocks is the opportunity to beat institutional investors. Because mutual funds have restrictions that limit them from buying large portions of any one issuer’s outstanding shares, some mutual funds would not be able to give the small cap a meaningful position in the fund.

  4. TraderMark |  Oct 05, 2007 at 2:59 pm

    Until the US economy gets back to serious strength probably large caps will out perform. They are more tied to the global economic boom and hence can take advantage of Chindia, South America etc – whereas many small caps are levered to the US economy.

    So I think its a bet of which economy is going to outpace the next few years? US or global? I bet global. By 2010 or so housing should have bottomed and I can see a return of small cap strength.