13 Small-Cap Funds on a Tear

The upcoming Labor Day weekend may mark the end of summer to some, but for investors it will mark the end of a nine-month period filled with incredible volatility, two lackluster earnings season and despite it all, incredible gains. The S&P 500, for example, is up 13.5% year to date.

But one of the biggest winners thus far this year are small-cap stocks. According to Morningstar, the average small-cap fund is up 19.3% this year through Thursday. In the fund world, the only groups outpacing small caps are their slightly larger midcap brethren and technology and energy sector funds.

We've spent a lot of time this year writing about the risks and rewards of investing in small company stock funds. This week the SmartMoney.com fund screen focuses on the 1,667 small-cap funds and share classes in our screener tool. We trimmed that group by searching for funds that had above average returns during the trailing three- and five-year time periods. The funds also had to be up by more than the S&P 500 this year. In addition, we favored funds with reasonable fees. That left us with 13 offerings.

Many advisors are adding to their small-cap positions for several reasons. Historically, small caps have performed well coming out of economic downturns. Investors are also regaining an appetite for risk after sitting on the sidelines for much of 2008. And there is also some opportunistic buying going on: The average small-cap fund dropped 37.2% during 2008, making plenty of good shares look cheap.

Larry Rosenthal, president of Financial Planning Services in Manassas, Va., doesn't think we will see the Dow skyrocket back up to 1440. But, he says, two to four years down the road, investors will look back and say what a great buying opportunity stocks were at today's prices.

While you may want to start adding to your small-cap positions, don't get carried away. The third-quarter earnings season, which is a critical one for measuring consumer spending, is on the horizon and poor results could mean that run-up will cool off. Small caps usually account for between 5% and 20% of a diversified portfolio (depending on age and risk tolerance).

Rosenthal has advised his clients to dollar-cost average into the sector in order to build a position over time instead of jumping in with both feet. "I definitely feel right now everything is rising and falling together," he says. If improved consumer spending isn't evident in the third quarter earnings reports, he believes stocks could pull back.

So which funds are among the biggest gainers this year? Funds from Royce, FBR, Gabelli and TCW are making return appearances on this screen since the last time we did it in April.

The Criteria: The small-cap funds on the table below are open to new money, require a minimum investment under $5,000 and charge less than a 1.5% annual expense ratio. In addition, they are beating the year-to-date return of the S&P 500 and feature performance track records that put them in the top 10% of their category during the trailing three- and five-year time periods. As usual, we did not allow load funds.

Fund Type = Small Cap
Annualized 3-Year Return (%) = Display Only
Rank in Classification (%) (3 year performance) <= 10
Annualized 5-Year Return (%) = Display Only
Rank in Classification (%) (5 year performance) <= 10
Expense Ratio <= 1.5%
Load Fund (type) = No Load
Minimum Initial Investment <= $5,000
Open to New Investors = Yes
Total Net Assets ($ millions) >= 50
Year-to-Date Return (%) = Display Only