How do I Invest in Small-Cap Stock Funds?

Virtually all stock market winners were small caps at one point.

Virtually all big stock market winners were small caps at one point, but small-cap fund performance can vary greatly from fund to fund, so the key to investing in small-cap stock funds is to find the fund with the best profit potential.

Instructions

1. Make sure that the market is favoring small caps. The market takes turns favoring small- or large-cap stocks. When money starts flowing into large caps, liquidity drains from small caps and they may underperform for long periods of time, regardless of the fundamentals. There's usually plenty of financial media commentary that tells you which segment the market is currently favoring. You can also compare the returns of large-cap vs. small-cap funds published periodically by many financial newspapers and websites.

2. Review the historic results for several time frames--six months, year-to-date, past 12 months, last three years--of all small-cap funds to identify the best overall candidates. Longer-term records are less meaningful because stock groups rarely outperform for more than five years and selecting a fund with the best five- or 10-year record may buy you plenty of past performance but little in terms of future profits.

3. See if the fund manager responsible for the recent gains is still with the fund. Mutual fund managers, particularly the ones with stellar track records, do not stay long in one place. A fund's stellar results may have been produced by a manager who has left, only to be replaced by a mediocrity. The fund's prospectus discloses managerial changes.

4. Check the fund's size. The smaller the fund, the greater the return potential. When a small-cap fund becomes too large due to recent popularity, it has more money than it can invest profitably so it is forced to invest in larger-cap stocks or mediocre performers just to stay fully invested, whereas a small fund can focus on the best stocks while still having room to grow.

5. Have sound sell rules. The key is not just to pick a great fund but to make money in it and keep it. Sell (a) if small-cap stocks begin to underperform and the market focus shifts to large caps; (b) when the manager responsible for the return leaves or (c) when the fund has grown too big compared with most peers.

Tips & Warnings

• Do not chase performance. Some investors like to buy the hottest fund with the best three- or six-month record. The problem with this approach is that next quarter, another fund may outperform. Stocks in small-cap funds may take more than three or six months to get going so frequent fund switching based on the latest results will buy you plenty of past performance but little future profit potential.

References

• FINRA: Mutual Funds
• "One Up on Wall Street"; Peter Lynch; 1989

Resources

• Yahoo! Finance Mutual Fund Screener