Small-cap funds should be in any portfolio, so don't let recent underperformance scare away clients.

    Is the bull market for small-cap mutual funds over?

Small-cap funds have been in the fast lane for eight long years, handily outperforming large-cap funds, the darlings of the stock market during the go-go 1990s. But in today's volatile market, shaken by subprime credit woes, weakening housing conditions, varying energy prices and hedge-fund blowups, investors are fleeing to the relative safety of large-cap funds. And in the perennial battle between growth and value, it would appear growth is back in the driver's seat-at least for now.

So is it time to toss in the towel on small-cap funds? For financial advisors, the challenge is to help clients navigate the rocky shoals and maintain their discipline with funds that can weather the ups and downs of the market regardless of their size and produce good performance over the long term.

Both large- and small-cap value funds have taken it on the chin during the last few months. Small-cap growth funds returned 6.61% year to date through July, according to Lipper Inc., while their small-cap value peers managed only a measly 0.25% for the same time period. Meanwhile, during that time, large-cap growth funds notched returns of 6.05%, versus 2.84% for large-cap value vehicles.

Further evidence that growth is in the driver's seat is that the Russell 2000 small-cap growth index has outperformed the small-cap value index over the last six months through July by more than 14%.

Has the market shifted in favor of large caps? Lipper stops short of saying that there's been a shift and that small-cap growth funds will start to outperform small-cap value funds. "At least over the last three months, it's been kind of off and on, but we're not ready to say whether it's a sustained period," says Tom Roseen, senior research analyst at Lipper. "In an economically bad time, it's often we'd be moving toward growth, but considering value has been strong the last four or five years, it might make sense for (investors) to rotate out of small-cap value and begin to take profits and move towards growth."

Nevertheless, it would be a mistake to advise clients to abandon the small-cap sector altogether. "A lot of people are saying small caps are passé. They're not," says Roseen. "We're just seeing a greater interest in the growthier side of the valuation chart. People are not necessarily going large cap. Rather, there's a stronger interest in mid-cap and multicap funds."

Many of the managers, advisors and experts we spoke to are not ready yet to surrender market leadership to large caps, despite their outperformance recently during the topsy-turvy market. Robert B. Greene, CFP, senior wealth manager at Tow Financial Advisors in Sherman Oaks, Calif., says small-cap funds should be a part of any diversified portfolio, and is holding clients' allocations steady. "One reason we like small-cap funds," Greene says, "is that smaller public companies with niche products and good management are seen as good candidates for acquisition by large firms. Small-cap funds that seek these companies are many times rewarded with premium buyout values. In a slower economy, larger firms will be seeking ways to expand their businesses, and acquisition will be one method. The ability to find buyouts will be impacted by the fallout in the subprime market. Firms with good credit, however, will still have options."

Satya D. Pradhuman, the CEO and director of research at Cirrus Research LLC and a former small-cap strategist at Merrill Lynch, says his research has shown that "with exogenous shocks, more liquid stocks go down harder." But then they often bounce back in good time, he notes, as happened in the wake of September 11, 2001, and the bankruptcy of WorldCom, albeit it was months later.

F. Thomas O'Halloran, who heads a five-member team managing the $869 million Lord Abbett Developing Growth Fund, expects small-cap growth stocks will continue to outperform small-cap value stocks for the foreseeable future. "The relative valuations between growth and value companies are attractive," says O'Halloran, "so growth is relatively cheap compared to value."