"There is this expectation that you are going to get higher returns for the extra risk," Hughes says. "So I think there are arguments for including smaller companies in your portfolio when you have a long time frame."
Investors, she says, need to be aware of the risks and diversify their holdings. Small caps, for example, carry some extra risk nowadays because one of the category's largest sectors is the financial industry.
Small caps, by their nature, tend to be sensitive to changes in their respective marketplaces and the general economy, she says. "Many of them have very non-diversified revenue streams, so they may be vulnerable to a downturn, but also levered operationally to an economic upswing. It just sort of magnifies the effect of the economy."
Likewise, changes in the credit market can hurt small-cap share prices more than those of larger-cap companies, she says. "On the flip side, when the purse strings loosen up, that can really be a big springboard for them."
For these reasons, advisors say they continue to use small caps as a basic building block in their client portfolios. "We certainly feel that small caps, even in this environment, have a place in portfolios-even for retirement planning," says Ekta Patel, managing advisor at Altfest Personal Wealth in New York.
For a 35-year-old client at her firm with a retirement portfolio invested mostly in equities, small caps would typically make up 10% to 15% of allocations, she says. Because of the resources required to carry out due diligence on small-cap companies, Altfest does not allocate any client assets to individual companies. Instead, Patel says, the firm relies on diversified small-cap mutual funds.
As a client gets older, the firm's small-cap allocations, along with all its other equity allocations, are drawn down to reduce risk, she says. Whether the small-cap portion remains in the account after the person has retired depends on the client's financial situation.
"I think it becomes zero if you are getting closer to reducing all other safer asset classes," she says. "When you are getting closer to depleting your account, you probably don't want small cap when you want room for bonds."
At SagePoint Financial in San Diego, clients typically have allocations between 5% and 12% in small caps, says Scott Wolters, a principal of the firm. His firm also relies on mutual funds for its allocations, which Wolters says isn't always easy. When the large-cap sector tumbled nine years ago, he says, investors ran to small caps, which prompted many quality funds to close to new investors.
"What we are looking for when we pick different funds is, whenever possible, a manager who has been there at least ten years," he says.