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Small-cap funds packing the biggest punch

– The biggest returns this year have come from the smallest stocks.

Indexes that track small stocks are at record highs. Small- and mid-cap stocks have dominated their larger peers over much of the current bull market, which began in 2009.

Consider mutual funds that invest in high-growth stocks. Those that focus on small stocks are up about 21 percent in 2013, according to Morningstar. That beats the 15 percent return for large-cap growth stock funds over the same time.

To be sure, their strong performance also means that small-cap stocks no longer look like bargains. Prices for stocks in the Standard & Poor’s 600 index of small stocks are trading at an average of 20 times their earnings per share over the last 12 months, according to data provider FactSet.

Here’s a look at reasons small-cap fund managers are optimistic, and at risks that investors must consider:

Higher growth

The most dynamic companies are small-caps, says Ralf Scherschmidt, who manages the Oberweis International Opportunities fund. It invests in small- and mid-sized stocks from around the world and returned 53 percent over the last year.

“Small-caps are inventing new products, where one or two new products can really change the fortunes of a company,” Scherschmidt says. “For Procter & Gamble, it will be very difficult for one new product to move the bottom line.”

Companies have begun reporting their second quarter results, and analysts are forecasting much bigger gains for small stocks. They expect the S&P 600 small-cap index to show 18 percent growth in earnings per share from a year earlier. That’s more than quadruple the 4 percent growth that they expect from the S&P 500 index of large-cap stocks, according to S&P Dow Jones Indices.

Next year, analysts expect the gap to remain wide. They forecast 26 percent growth for small-cap stocks as opposed to 13 percent for large-caps.

Aimed at America

The economic recovery appears to be gaining steam. Home prices are rising, and employers are adding workers. The trend has been encouraging enough that the Federal Reserve has discussed slowing its stimulus.

The rest of the world has more question marks: Investors are worried about slowing economic growth in China, and the eurozone’s economy is shrinking.

Such a dichotomy can mean good things for small-cap stocks, relative to their larger competitors. “By and large, you’ve got more of a domestic focus with small-caps, and that’s the place you want to be right now,” says Eric Mintz, portfolio co-manager for mid-cap and small-cap growth strategies at Eagle Asset Management. His $3.6 billion Eagle Small Cap Growth fund ranks in the top 20 percent of its category for 10-year returns.

Potential drawbacks

Although small-cap stock funds often do better than large-cap funds when the economy’s healthy, they can also fall faster when conditions are souring. When markets flailed in the third quarter of 2011 – after Standard & Poor’s downgraded the U.S. credit rating in August and Europe’s debt crisis was worsening – small-cap growth stock funds lost an average 22 percent. That was a steeper drop than the 16 percent loss for large-cap growth funds.

Another risk: rising interest rates. The yield on the 10-year Treasury has climbed to 2.6 percent from 1.6 percent in early May. If rates keep rising, which most analysts expect, smaller companies may find it more difficult to borrow cash needed to grow.