DURING THE CHRISTMAS season last year in Indianapolis, father-and-son team Bryan and Robert Auer launched their first mutual fund, Auer Growth. At the same time, about 800 miles south, a similar situation was playing out in Dallas. There, Hodges Capital Management, a firm well-known for its namesake multicap offering, introduced Hodges Small Cap. Year to date both small-company stock funds have beaten the returns of the broad market.

In recent months more than a dozen prominent funds from competitors like Royce, Allianz, Third Avenue and Wasatch re-opened their doors to new money. Many of the managers at these offerings were dealing with asset outflows at the same time they were seeing an unprecedented amount of bargain stocks in the market place. In some cases, these funds opened for just a few weeks, took in the amount of money they needed, and then proceeded to close their doors once again. They had no problem attracting investors.

That's a lot of action for a fund category that had supposedly been left for dead the last few years. After a strong rally in small-company stocks earlier this decade started showing signs of fizzling out, investors segued into large caps instead in 2006 and 2007. Now, though, the category appears to be poised for a comeback. Managers are finding an abundance of well-run, strong-growth companies that are trading on the cheap. Advisors are ratcheting up their clients' exposure to these funds. Research also shows these stocks tend to lead the broad market out of recession-type periods. Indeed, that seems to be happening. According to Lipper, the average small-cap fund has lost about 10% in 2008. That's nothing to cheer about, but it is almost four percentage points ahead of S&P 500 index funds.

It just may be the time to give these funds another look. Small caps typically account for a minimal (10% or so) position in the average portfolio. The funds are there for diversification, but when they get going they can have a profound impact on overall returns. After the last bear market, small-cap stocks went on a five-year run. Indeed, FBR Focus, one of the top funds to center on small and midcap stocks, returned an average annual 10% between 2003 and 2008. That beat the broad market by three percentage points.

Small caps fell out of favor for several reasons. The sector's best stocks appeared to be fully valued (so much so that many small-cap funds found themselves listed as midcap offerings). When the economy slows, small caps run the risk of seeing the costs of finance escalate, if they can get it at all. At the same time sales of key products in many cases these companies have just one product can fall off a cliff. So when the market started to tank recently investors headed for the safe harbors afforded by the market's largest blue-chip stocks. Those shares have a history of weathering storms.

But let's get back to that bear market point. Data from Ibbotson show that dating back to the 1950s, in the months after a recession-type period, small-cap stocks tend to lead the broad market (although the gap starts to close after two years). That's a pretty strong data point to hang an investment decision on. The problem is that this current market may not be like any that have come before it. Indeed, investors are dealing with record energy prices, inflation, a virtual collapse of the financial-services and housing industries, the rise of emerging markets and a war overseas. All that could certainly spell trouble for any category of stock funds.

offering.

Wasatch Small Cap Growth
Manager: Jeff Cardon
Top Holdings *	Returns
O'Reilly Automotive	3-Year Average Annual Return: -2.9%
Knight Transportation	5-Year Average Annual Return: 4.5%
Techne Corp.	10-Year Average Annual Return: 9.4%
Power Intergrations	Assets (In Millions): $803
Resource Global Professionals	Minimum Investment: $2,000

Source: Morningstar

Note: Data as of July 30,2008

* Holdings may have changed since the fund's last filing

Stewart agrees that small-cap stocks are showing signs of coming back. He just isn't sure if the timing is right. "One the one hand I think small caps are interesting [right now]," he says from his office in Salt Lake City. "But what has everybody confused is that a year and a half ago everybody said small caps were long in the tooth and switched to large caps." Now, he says, people are wondering if this recent rally is genuine or a "head fake." In other words, instead of small caps rallying early in the cycle they could just as easily run up late in the cycle, too.

In any case, investors would have a hard time finding a better fund for small-cap exposure than the $803 million Wasatch Small Cap Growth. This fund has been run since 1986 by manager Jeff Cardon. That's a tenure investors will rarely find in this sector. The fund charges a decent $119 a year for every $10,000 invested and its average annual 9.4% return over the trailing decade puts it in the top 11% of its category. Top holdings include O'Reilly Automotive, Knight Transportation and Techne, a manufacturer of health-care products. The firm prides itself on bottom-up research and right now that homework is telling them to be underweight energy. "As we scour the globe for interesting energy companies, skyrocketing valuations remind us of the dot-com boom," Cardon wrote in a recent note to shareholders.

Other worthy funds are FBR Focus and Keeley Small Cap Value. The Keeley fund specializes in investing in corporate spinoffs. It's in the top 5% of its Morningstar category over the trailing one-, three-, five- and 10-year time periods. (However, Keeley does charge a 4.5% load.) FBR Focus has been run by Chuck Akre since its inception in 1996. One of his main stock-picking criteria is to find companies with at least sustainable 20% returns on equity. This fund has returned an average annual 11.4% the last decade.

And we can't forget about the new kids on the block. We usually shy away from reviewing brand-new funds, but Auer Growth and Hodges Small Cap have a pedigree we like. Auer's contrarian strategy hinges on a dozen criteria, including stocks that have quarterly earnings growth of 25% and quarterly sales growth of 20%. The fund has 50% of its assets in small and microcap stocks. However it can also climb the market-cap ladder if its managers find good buys. "We sometimes zig when the market zags," says Bob Auer. More important, though, is that the SEC allowed the Auers to include a 20-year track record in the prospectus for when the fund was private. That track record puts it at the top of its category (although the last month of returns has been a bit painful). It is a little pricey at 1.95% a year and the $10,000 minimum is high. But this fund is worth keeping an eye on. Click here to see a video of Bob Auer discussing some of his top picks.

, has used so effectively the last five years. (It has returned an average annual 15.8% during that time period.) In fact, the genesis of the new fund was the performance of the small-cap sleeve in its larger brethren. One of the primary managers on the fund, Eric Marshall, has been the firm's director of research since 1997. The fund has returned 5.8% since its inception last December vs. a loss of 19% for the broad market. "It turned out to be a good time to start a fund," says Marshall.

Also See:

• 1st Source Fund Quietly Beats the Competition

• Dividend Funds Can Lessen Risk to Income

• The Buzz Among Fund Managers