Small-cap strength seen as bright sign

The recent popularity of small-cap mutual funds may be a sign that recession is giving way to recovery.

Since 1953, small-cap funds have gained an average of 34% in the year after a recession ends, according to research conducted by JennisonDryden, the money management unit of Prudential Financial Inc. of Newark, N.J., which was cited in a white paper published by Wasatch Advisors Inc. of Salt Lake City, a firm that offers predominantly small-cap funds.

The white paper and data interpretation were done by Wasatch.

Research for the paper was conducted by JennisonDryden, the investment subsidiary of The Prudential Insurance Company of America of Newark, N.J.; the white paper and data interpretation were done by Wasatch.

U.S. small-cap funds posted net inflows of $1.7 billion year-to-date through April 30, while large-, multi- and mid-cap funds all posted net outflows, according to New York-based Lipper Inc.

Some of the attraction could be returns.

Of the 572 U.S. small-cap funds tracked by Chicago-based Morningstar, the funds posted an average return of 9.94% year-to-date through June 10, compared with the 3.97% return of the Standard & Poor’s 500 stock index.

Small-cap stocks are more sensitive to changes in the economy because they have a less diversified revenue stream, said Bridget Hughes, associate director of fund analysis at Chicago-based Morningstar Inc.

“In terms of the volatility, their performance can be more exaggerated. They are more dependent on credit and bank lending than larger companies,” Ms. Hughes said.

“If banks decide to lend only to the bigger brand names, it could be a little difficult for small-caps, which could derail the small-cap rally,” said Tom Roseen, senior research analyst at Lipper.

“We advocate for portfolios to have an exposure to small- or micro-cap funds through all market environments,” said Mark Willoughby, principal at Modera Wealth Management of Old Tappan, N.J., which has $400 million in assets under management.

“We are an asset allocation shop. For us, it’s a matter of looking at it from a re-balancing position. We’ve been buying micro-cap and small-cap funds because they’ve fallen below their targets in the portfolios,” Mr. Willoughby said.

Some advisers have already adjusted their portfolios by adding small-caps.

“We cut our international allocation at the end of last year, primarily over concern about the recovery in Europe,” said Chris Brown, president of Ivy League Financial Advisors LLC of Rockville, Md., which has $60 million in assets under management. “We believe the order of the recovery will be the U.S. first, followed by Asia and then Europe.”

The firm reduced international exposure to 8%, from 15%.

“We took that allocation and put most of that in small- and mid-cap funds,” Mr. Brown said.

But not all advisers are on the small-cap bandwagon, said David Fernandez, president of Wealth Engineering LLC of Scottsdale, Ariz., which has $40 million in assets under management.

“Small companies need credit to continue to grow and replace inventory,” he said. “The capital markets and credit markets have tightened up so much. I think it’s only going to get worse.”

If investors need to buy more equities, they should do it by dollar cost averaging, Mr. Fernandez said, and they should consider U.S. large-caps, which have better access to credit.

“We’re not market timers,” said Jeff Bernier, chief executive at TandemGrowth Financial Advisors LLC of Alpharetta, Ga., which has $60 million in assets under management.

“There are those who say that the best opportunities today are in the higher-quality large-cap stocks because they got beaten up so much,” he said.

The main goal is to have a balanced portfolio, Mr. Bernier said.