"There are fewer things on the planet more vigorously marketed than common stocks. Wall Street is literally pumping up stocks day in and day out," he says.
That leads to more liquidity and marketability, but also artificially inflates expectations and prices. In the less-well-known universe of small caps, he argues, investors get a more efficient market. "If companies ultimately put up numbers and perform, their prices will reflect that," Roumell says.
These are among the reasons why, for those who want to build a portfolio that emulates the entire market, small caps are almost a mandatory part of a diversified portfolio.
Target-date mutual funds-the "set-and-forget" products that are designed as risk-managed retirement savings solutions for individual investors-typically devote a percentage of their equity allocations to small caps. At T. Rowe Price, one of the leading target-date fund providers, small-cap equities currently represent about 11% of domestic equity allocations, according to Ned Notzon, chairman of T. Rowe Price's asset allocation committee.
That represents a slight underweighting, he notes, due to the run-up in small-cap values in the recent market rally and a favorable outlook for large caps. "Going forward, the large-cap stocks will probably benefit more if the global economy improves," he says.
At ING Investment Management, a small-cap allocation makes up a portion of the firm's target-date funds until the investor's retirement, when they are phased out, says Seth Finkelstein, a portfolio manager on ING's multi-asset strategies team. The company's 2045 target-date fund, for example, devotes 95% of its allocations to equities, of which 10% is small cap. By comparison, large caps make up 44% of the equity allocations and international is 21%.
While ING expects small caps to outperform large caps over the long term, the spread between the two categories may tighten, Finkelstein says. Over the next seven to ten years, ING expects small caps to bring an annualized return of 10.5%, while large caps bring in 9.5%.
This tightening is largely due to the expansion of the global economy, he says. "We anticipate a weak dollar and higher exports, which favors large-cap companies given that they do have more exports and revenue," he says.
Small-cap allocations in a retirement portfolio should vary, depending on factors such as an investor's total assets and investment horizon, says Bridget Hughes, an associate director of fund analysis at Morningstar.
Historical data show that small caps, particularly small-cap value, outperform larger-capitalization categories over a long period of time, she notes.
This has been the case in recent years. Over the past ten years-a period of time some have labeled "The Lost Decade" for market investors-the Russell 2000 value index has brought an annualized return of 6.4%. That beats all other asset class categories, including the large-cap Russell 1000, whose annualized return is down 0.72% for the period.