3 Ways to Invest in the Small-Cap Rally

Risk and volatility are back on the table. The stock market rally of 2009 is long gone. Experts are worried that the economic recovery in the United States is a fragile one, and the markets are reacting wildly to any news—whether good or bad.

"What we've clearly seen in 2010 is that volatility has returned and that the market can go down and not just go up," says Todd Rosenbluth, equity analyst for Standard & Poor's. "If you're going to invest in domestic equity funds, you need to take risk into account in the investment decision."

[See U.S. News's list of The 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

Since the beginning of the year, the S&P 500 (an index made up of the largest 500 stocks in the U.S.) is down about 1 percent. There is a world of smaller stocks outside of the S&P 500 that investors can use to diversify their portfolios beyond just the big-name American blue-chip companies. Small-cap stock funds generally invest in stocks that have a market capitalization of less than $2 billion. The Russell 2000 index (the most commonly cited small-cap index, which tracks the smallest 2000 stocks in the Russell 3000) is up almost 1 percent so far this year. Year-to-date, small-cap value funds are the second-highest performing asset class among domestic stock funds (behind only real estate)—up more than 4 percent so far this year, according to Morningstar. Because some of these companies have less stable records of reporting earnings and less is known about them, they're generally considered more volatile than mid- or large-cap stocks. But if small-cap stock funds are appropriate for your level of risk tolerance, there are a number of funds with decent track records.

[See What Investors Can Expect From Large-Growth Funds.]

Their beta—how they move either up or down compared to the rest of the broader market—is typically higher. If, for instance, a mutual fund has a beta of one then that means it has moved in line with the rest of the broader market. Funds with a beta higher than one are considered riskier, while funds with a beta of less than one are considered less volatile. As of June, the average beta for each small-cap fund peer group was higher than 1.17, according to S&P. "So typically in down days of the market, lower beta mutual funds will go down less, and in up days of the market, higher beta funds will go up more," Rosenbluth says. "There are pluses and minuses to it."

S&P recommends that investors allocate 40 percent of their portfolios to U.S. stocks (down from 45 percent in June), and of that S&P suggests that investors place 2 percent in small-cap stocks (whether it be through mutual funds, exchange-traded funds, or just plain old stocks). For investors who have been scared off by recent volatility, Rosenbluth highlights three mutual funds that are highly ranked by S&P and have a low beta compared to their peers.

Intrepid Small Cap (ICMAX). This small-cap value fund has a beta of 0.71—the lowest of the three funds selected by Rosenbluth. Its returns rank among the best in its category. Over the last three years, the fund has had an average annualized return of about 12 percent. In 2008, when the average small-cap value fund plummeted about 32 percent, the fund only lost about 7 percent. Management has proven that it's not afraid to get defensive. In early 2009, management invested as much as 20 percent in cash, according to Morningstar. Now, the fund has invested about 10 percent of its assets in short-term U.S. treasuries to combat the recent market volatility, according to S&P.

Wasatch Small Cap Growth (WAAEX). Manager Jeff Cardon believes there is too much discussion over whether or not small-cap funds are riskier than large-cap funds. His team's focus is on high-quality versus low-quality companies. About 75 percent of the stocks that management is holding now have no debt, according to Cardon. As for the other holdings, he says they may have some but only because they've made a big move recently like acquiring a new company, which forced them to take on some debt. The fund's beta stands at about 1.1. Over the last 10 years, the fund has returned about 5 percent annualized, on average, which places it in the top 10 percent of its category. "We do better in down markets," Cardon says. He says his focus is on quality, so the fund may, at times, miss out on speculative rallies. "If you assume we're going to be in a period where there's going to be lower long-run economic growth and there's going to be no bubble formation, then that's a pretty compelling backdrop for investing in quality companies that do it the old-fashioned way where they have real growth opportunities that aren't just generated by Wall Street," he says.