Small-cap bloodbath

NEW YORK – May was an ugly month on Wall Street, but it was especially bloody for small-cap mutual funds.

Higher interest rates and a slowing economy mean more investors are shifting money away from companies with small market capitalization into larger, less risky companies. High price-to-earnings ratios also mean less interest in small caps, which have been so good to investors the past several years.

But if your first reaction is to clear your portfolio of small-cap funds, analysts and advisers preach patience. Spreading holdings among companies with big and small market capitalization – just like spreading risk between domestic and international markets – helps you diversify and balance your portfolio’s risk, they say.

That’s also because, in part, analysts are also hesitant to declare the end of small-cap funds’ dominance.

Small-cap growth funds posted a negative 4.2 percent return for the month ended June 1, compared with a 3.9 percent loss for mid-cap growth funds and a 3 percent loss for large-cap growth funds.

Among value funds, meanwhile, small-cap funds declined 2.2 percent over the month, compared with a 1.5 percent loss for mid-cap value funds and a 1.2 percent loss for large-cap values.

It’s a departure from small caps’ recent impressive performance. Small caps easily outpaced mid-caps and large-caps through the past three years – the average small-cap value fund has posted a 21.1 percent average annual return over the past three years, compared with 18.6 percent for mid-cap value funds and 14.2 percent for large-cap value funds.

Over the past five years, small-cap value funds have posted a 13.1 percent average annual return to mid-cap value funds’ 10 percent and large-cap value funds’ 4.6 percent.

How much an investor should keep in small-cap funds depends on his or her risk tolerance; smaller companies are generally more volatile than larger ones.

David Joy, chief market strategist for money manager RiverSource Investments, said he began pulling out of small caps nine months ago, setting them at 5 percent of his portfolio from 7 percent. He moved the money into large-cap companies.

He admits that was likely premature, but he said the signs point to large-cap stocks pulling ahead of small caps.

Higher interest rates make borrowing more difficult, which makes growth for young companies more difficult, while affecting established, large-cap companies less, he said.

A weaker dollar also tilts the benefit to larger companies, which tend to have more overseas revenues and can benefit from a better exchange rate.

Morningstar mutual fund analyst Sonya Morris warns against reading too much into one month’s performance, especially for a month that was so hard on almost all stocks. She urges investors not to panic and dump their small-cap exposure.

“May was really a broad-based blood bath,” she said. “It was hard to avoid this one, and we urge investors to stay the course.”