Small cap stocks might have run out of steam

When it comes to investing in 2014, small cap stock funds are likely to come in last place among investments. All three small-cap fund categories—growth, value, and blend—lost value through the first seven months of the year. Other than European equities, small-caps have been the only major asset class with negative returns this year.

Previously, small caps had an impressive run. From January 2010 until the beginning of this year, small-cap stocks returned 18.4 percent annually, outperforming Standard & Poor’s 500 Index large-cap stocks by 2.5 percentage points.

But so far in 2014, as large-cap stocks regularly plumb new all-time highs, small-caps keep testing new lows. One probable cause: As measured by the price-to-earnings ratio, small-cap stocks have been significantly more expensive than large-caps for an extensive period of time. A year ago, large-caps were priced at 17 times earnings—a level that is considered by most observers to be neither expensive nor cheap. But small-caps traded at 21 times earnings (a 24 percent markup in price) and still do. On a relative basis, they’ve become too expensive.

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What we’re seeing is a textbook example of the way the market moves: Small-caps outperform immediately after the end of a recession (the last one officially ended in June 2009), only to lose steam as the economy begins to improve. Later, as the economy fully recovers, large-cap stocks tend to be the ones that outperform.

Of course, markets have an unfortunate habit of sometimes not following the textbook. And one would still have to gauge when, exactly, a recovery reaches middle age to begin to shift from small-cap to large-cap stocks. (Historically, economic rebounds have lasted as little as one year or as long as 10.) The easier solution is to own both and diversify between them. Investors who own large-caps exclusively may be forgoing additional gains. Since 1926, small-caps have returned 2 percentage points more annually than large-caps.

As usual, we screened for funds that most consistently beat the fund category average over the past five years, as well as for the most popular low-cost exchange-traded funds. A couple of caveats about this month’s funds: Huber Capital Small Cap Value, though the most consistent fund, has done especially poorly in the past 12 months, despite a stellar record in the preceding four years. And the Vanguard Explorer fund, one of the few actively managed equity funds Vanguard offers, has an expense ratio of 0.52 percent—cheap for active funds but more expensive than its usual index-based offerings, which average 0.18 percent annually.—Chris Horymski

This article also appeared in the October 2014 issue of Consumer Reports Money Adviser.