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."

He continues: "In volatile times like we've had over the past couple of months, I would expect large caps to outperform small caps, but it's too early to conclude that small caps have lost their market leadership. It could be that we're late in the cycle, but if the credit situation gets clarified, I wouldn't be surprised to see small outperform large."

Echoing O'Halloran, Daniel Perkins, who is part of a father-son team managing the $42 million Perkins Discovery Fund, a microcap vehicle, says, "It's still not clear if large-cap stocks are moving into the lead. The small-cap leadership has gone on for eight years, which is quite a while, but they have led for longer periods in the past. The trend hasn't clearly changed yet."

Likewise, Steven T. Merkel, CFP, ChFC, and vice president of portfolio management at Financial Advisory Consultants in Naples, Fla., says, "The spin is that small caps are more risky than large caps. But over time, small caps are more rewarding than what you would get from a large-cap investment."

Royce & Associates, a firm that deals exclusively with small caps and has $32 billion under management, is a good proxy for the value investing style in the small-cap world. Even its growth funds are more value oriented than the average small-cap growth fund. Five-year-old Royce Value Plus Service, with $2.75 billion in assets, for example, has been a top fund in Morningstar's small-cap universe for the past three years.

"We've done better than the Russell 2000 index in this fund in all four down markets except one since 2004," says the fund's manager, James A. "Chip" Skinner III. "Our main focus is to preserve capital. We get a kick out of outperforming when times are tough."

Though he buys primarily as a value manager, Skinner is not afraid to buy a growth company as long as it has a good balance sheet and he doesn't have to overpay for it. In that vein, he's been adding technology stocks to the fund's portfolio as he's noticed IT spending in that sector has increased. He also has started bulking up on precious metals stocks. With the increase in precious metal prices, "Gold and silver have taken on a more serious investment status," he notes.

Two other Royce managers, Whitney George and David Nadel, co-heads of Royce Global Select Fund, see the market's turbulence as part of the normal rotation cycle between small-cap and large-cap companies, and view it as a buying opportunity. "It's an evergreen universe, and particularly when people feel more confident about their investing they tend to gravitate towards it," says George, a 16-year veteran with Royce. "We look at the world on a three- to five-year basis, and we would view those kinds of corrections as good times to buy smaller companies because, over the longer term, given our approach, they have done better."

Royce Global Selection was launched slightly more than two years ago. The preponderance of its portfolio is in U.S.-based stocks with a significant foreign exposure. With an investment minimum of $50,000, the fund is tailored to advisors and high-net-worth investors. It has a hedge-fund-like performance fee. The fee is 12.5% of its high watermark performance, meaning in a flat or down market, the fund bears the expenses and charges no management fees.

Instead, Royce absorbs it, says Nadel. Both he and George are investors in the fund. "We eat our own lunch," says Nadel.

As for his outlook on the international sector, Nadel says good buys exist in such markets as the United Kingdom, Brazil, South Africa, Finland and Japan. Meanwhile, in his opinion, "Systemic risks of the past in international investing, be they fluctuations in currencies, inflation or interest rates, have been structurally reduced."

Lord Abbett Developing Growth, one of the oldest funds in the small-cap category, launched in 1973, follows a solid growth strategy. O'Halloran looks for "best of breed" companies in the small-cap arena enjoying strong revenue and earnings growth. They must have a resemblance to a successful larger company. Morningstar, for example, has been a holding for three years. "When we bought it on its IPO in the first half of 2004, we characterized it as a baby Moody's [Investors Service]," says O'Halloran.

He sees future growth opportunities in both Internet and alternative energy stocks. On the Internet side, he especially likes Equinix (EQIX) whose server "farms" host traffic across the Internet. A favorite alternative energy stock is Solar Energy (SPWF).

The Perkins Discovery Fund has been among Morningstar's top funds in its category. Since its birth in 1998, the fund has posted a 19.14% annualized return through June 2007. And over the past five years through June, it has returned 21% on an annualized basis, compared with 13.87% for the Russell 2000 index.

The fund has a bottom-up approach, meaning it looks for stocks one by one, as opposed to by sectors. The bulk of its 64-stock portfolio is in medical, technology, software and energy, all sectors the managers are betting on for the future. A favorite medical stock is Matrix Initiatives (MPXX), which produces cold remedies. Union Drilling (UDRL), which operates and leases out close to 80 natural gas drilling rigs, is another favorite, along with Vivus (VVUS), whose current products are primarily for erectile dysfunction.

Financial Advisory Consultants, with $167 million under management, is holding its small-cap allocations steady. Says Merkel: "Even considering the pressure we've received from some clients to eliminate small-cap growth funds, due to their underperformance compared with small-cap value funds, we've encouraged clients to hold their small-cap growth positions. We don't think you should give up on small-cap value or small-cap growth, and move into larger caps. You'd be setting yourself up for failure."

He adds: "It's kind of the theory that every dog has its day. Small-cap value will outperform small-cap growth in certain time periods, and the reverse is true for others. The most difficult thing is controlling that irrational behavior of clients."

Greene is holding firm as well. "At this juncture, we are not reducing our allocations. We have a minimum allocation to small caps, typically 2% to 4%, depending on the client. We have also been overweighted in  large-cap funds for some time. It's important to remember, however, that for long-term investors, small-cap funds have outperformed large cap; therefore, we maintain an allocation."

Greene especially likes Heartland Value Fund, a small-cap value fund in existence since 1984 with the same manager. "They utilize a vigorous screening program and have had favorable long-term performance results," he says.

Other advisors, however, are not waiting for the dust to settle. Lewis J. Altfest, CFP, CFA, CPA, a principal of L.J. Altfest & Co., a wealth management firm in New York with $500 million under management, cut his firm's small-cap fund allocations from 10% to 6% some time ago, he says. Meanwhile, he has upped his large-cap fund exposure from 18% to 24% of clients' portfolios.

"It just seemed to us we weren't getting good valuations from small-cap funds," says Altfest. "Valuations are about at their highs relative to large-cap funds. The standard deviation for small caps is right alongside that for international stocks."

Bruce W. Fraser, ([email protected]) a freelance financial writer in New York, contributes to many publications and is writing a book on millionaires. Visit him at www.bwfraser.com/home.