7 Funds for Exposure to Small-Cap Value

The stock market doesn't discriminate when things start to go south. Indeed, according to Lipper, every major mainstream fund category has lost money in 2008. And the broad market as a whole is down 16.6% year-to-date through Thursday.

But Eric Nelson, chief investment strategist at Burns Advisory Group, a money-management firm in Oklahoma City, thinks he sees some light at the end of the tunnel, at least for one category. Nelson has been crunching the numbers on small-cap-stock funds, especially small-cap-value ones, and says they are ready to lead the market out of this mess. It appears history is on his side. Nelson looked at 10 downturns in the market during the 1970s, '80s, '90s and earlier this decade. In the 12 months following those declines, small-cap-value stocks beat the broad market nine of out 10 times (the exception being 1998-99).

"Certainly nobody is able to call the bottom," says Nelson, but "as you see small caps start to pull ahead it could indicate the start of a potential recovery."

There are caveats to Nelson's thesis, which we'll get to later, but armed with his data we decided to turn the spotlight on the small-cap-value category this week. There are 316 funds and share classes in our Lipper database that are part of this group. We knocked out 261 that charged sales loads. We then looked for funds with three- and five-year track records that put them in the top 40% of this category. The funds also had to charge less than a 1.5% annual expense ratio. That left us with seven finalists. They are listed in the table below.

Small caps are one of the riskiest domestic equity fund categories. When the market takes a turn for the worse, these stocks tend to fall faster and harder. That's because many small businesses depend on access to capital markets or loans to fund their operations. In tough economic times it becomes more expensive to borrow cash -- lately it's become difficult to borrow at all -- and that leads to weaker balance sheets. Small companies can also be one-hit wonders. Sales of a popular product can crater because consumers or big corporations do some belt-tightening. Meanwhile, blue-chip companies, which have a broader array of products, become investors' safe havens for their abilities to weather any storm.

Nelson argues the opposite happens once the market recovers. When the cash spigot is turned back on these companies are first in line to benefit. All of the sudden they have the funds to grow their businesses. As small companies raise their profiles they become acquisition targets for bigger competitors, which can lead to a deal that cashes out shareholders at a premium. This time around, relatively low interest rates and a government bailout plan -- if one gets approved after all the wrangling -- will help these funds' cause, too. As investor confidence builds they become more comfortable investing in what was considered too risky just months earlier.

Nelson says there is usually a three-month lead time to this phenomenon. If that's the case, then it appears this is the perfect moment to think about purchasing a small-cap-value fund, at least for a small portion of your equity portfolio. Indeed, that's an idea we trumpeted during the summer. And it coincides with what many small-cap fund managers were saying at the beginning of the year. There was a rash of small-cap fund re-openings in the first quarter of 2008 because managers were seeing too many bargains to pass up. They wanted cash to buy those stocks without having to sell others in their portfolios to raise the funds.