The Year of the Small-Cap Mutual Fund

Why small-cap funds have been shining.

Why small-cap funds have been shining
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Mutual funds owning bite-sized companies have been raking in outsized returns so far in 2013.

In a year in which virtually all forms of stock funds have performed well, small-cap funds are leading the pack. As of July 10, small-growth, small-blend and small-value funds (in that order) nabbed the first, second and third spots on Morningstar's list of year-to-date returns for domestic equity fund categories. The average fund in each of the three small-cap categories has returned in excess of 20 percent so far this year. That beats out large-growth funds by an impressive six percentage points.

[Read: Are the Industry's Most Famous Stock Pickers Beating the Market?]

But even as the stock market heats up, equity investors have been doing more selling than buying. During the week ending July 2, for instance, domestic stock funds saw more than $2 billion in outflows, according to the Investment Company Institute.

What has changed recently, though, is that bond funds, which had long been soaking up investors' money, are now starting to share in the pain. For instance, during the week ending July 2, bond funds lost nearly $6 billion; the week before, it was more than $28 billion. These outflows have come amid dismal performance in the bond market. As of July 10, for instance, long-term bond funds were down more than 11 percent in 2013. Some of the best-known bond funds have been among the biggest victims of the outflows. In June alone, PIMCO Total Return, the world's largest mutual fund, shed $9.6 billion.

[Read: 8 Things You Need to Know About Buying Bonds Now.]

Overall, the success of small-cap funds this year hardly comes as a surprise. During rallies, small companies often perform better than their larger counterparts. And in a year that has brought record closings for both the Dow Jones Industrial Average and the Standard & Poor's 500 index, conditions have been prime for small companies to shine.

Nonetheless, the factors that make small-cap funds pay off so well during strong market cycles also make them risky. Trading stocks of smaller companies is more speculative than trading large, established blue chips. That means in times of market panic, small-cap investors often get hit the hardest.

With that in mind, here are three factors to consider when thinking about buying into a small-cap mutual fund:

Liquidity. Stocks in larger companies are traded with such frequency that investors don't have to be concerned they won't be able to purchase shares when they want them or sell them when they feel like getting rid of them. That's not necessarily the case with all small companies. Sometimes, of course, talented managers can make significant profits by investing in companies whose shares do not experience heavy trading, but such opportunities come with risks. As with most types of risks, liquidity risks are mitigated in portfolios that are highly diversified.

[See: Risky Business: 7 Mutual Funds for Gamblers.]

Size. The term "small cap" covers a wide range of stocks. Although there is no uniform definition, the most common one is that any stock with a market capitalization of under $1 billion qualifies. That means small caps can be anything from penny stocks to shares of relatively well-established companies. Typically, the smaller the market cap, the higher the risks and the greater the potential rewards.

Management. For non-index funds, strong management is perhaps more important in small-cap funds than it is in any other corner of the domestic stock market. Small companies often have relatively little research dedicated to them, and separating the wheat from the chaff can be difficult. Given those challenges, small-cap funds typically have relatively high expense ratios. Finding a fund with an established team of managers and researchers helps ensure you get what you pay for.