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I am a big fan of small-cap funds. At one time, I had several small-cap funds, both value and growth, in my taxable investment accounts. Though I have trimmed the number to two, they are still a significant portion of my portfolio as small-cap is nearly a quarter of my taxable mutual fund investments.

The reason for having a large small-cap investments is quite simple: Historically, the return from small-cap investments is 2% higher than the return from large-cap stocks. Since the burst of tech bubble in 2001, small-cap stocks as a group have outperformed large-caps each and every year. The following is a chart comparing Russell 2000 (small-cap) and S&P 500 (large-cap) for the past five years. The superiority of the small-cap is evident.

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The argument for the better performance of small-caps during the recovery from a recession is that small companies can respond quickly to the change in market conditions. However, when the economy enters the normal growth mode, large companies have an edge over their small rivals because of the advantage of their ability to obtain capital to sustain growth.

It has been quite a well since some experts predicted that in the current economic cycle, small-caps have run their course and it’s time for large-cap to shine. After some delay, that prediction may finally come true. The following is the YTD performance comparison of the Russell 2000 and S&P 500. What I see from the chart is that every time stocks dropped, especially since the credit crisis began in July, small-caps went down even further while the rebound wasn’t as strong as the large-caps experienced. That’s understandable because during the credit crunch, small companies could feel more pain from the rising cost of credit.

rut_ytd.png

Year-to-date, the S&P 500 has returned 9.03% while the Russell 2000 has gained 5.60%. 2007 could be the first year in a while that large-cap outperforms small-cap. Does it signal that the small-cap party is finally over?

Source: The Smallcap Party May Be Over