With the economy continuing to plod along, many analysts believe that a full-on recovery isn't in the cards until banks return to their normal lending patterns. According to the Federal Reserve, bank loans are still down more than 20% from their 2008 highs. With nearly $1.8 trillion in cash sitting on S&P 500 companies' balance sheets, large companies have had relatively no difficulty slugging through the quagmire. Small caps, which require credit to function, have been an anomaly, rallying nearly 12.3% this year. Despite doubling the performance of the SPDR S&P 500 ETF (NYSE:SPY), the real gains for small caps are still ahead.

IN PICTURES: 4 Biggest Investor Errors

Thinking Small
As credit remains tight, smaller companies haven't received the loans many need for expansion. This normal aspect of the business cycle hasn't kicked in yet. When it finally does and credit loosens it will help boost small caps even higher. These companies will be able to buy more equipment, increase hiring and produce more goods. Due to their size, all of these things will quickly manifest themselves in small cap's bottom lines and revenue. Small caps tend to benefit in low interest rate environments. With the Federal Reserve promising to keep rates at all-time lows for an "extended period of time," these companies do not have to pay much capital in order to fuel growth.

In addition, since the Great Depression, small caps have done well in long-term secular bear markets. If the market continues to move sideways for an extended period of time, firms with smaller market capitalizations should do well. Finally, due to their agility, small companies also tend to benefit more quickly from economic rebounds. Once the economy gets really cooking and shows some resemblance to normal patterns, small caps will certainly jump back.

Small Additions
Benefiting from a return to normalcy or a sideways market, small caps should be part of every investor's portfolio. Investing in individual small stocks can be quite lucrative, especially if they turn out to be the next Wal-Mart (NYSE:WMT). However, by investing in single companies, investors ratchet up their risk. There are plenty of ways for investors to add a basket of small caps and gain diversification benefits.

The mother of all broad small-cap ETFs is the iShares Russell 2000 Index (NYSE:IWM). Trading nearly 60 million shares daily and nearly $13 billion in assets, the fund is the go-to pick for domestic small-cap exposure. The fund holds almost 2,000 individual small caps across a pretty even balance of sectors. Investors may also want to consider the iShares S&P Small Cap 600 Index (NYSE:IJR), which has slightly outperformed the Russell.

For investors willing to use a higher power on their microscope, micro-cap stocks or stocks with market capitalizations below $300 million might be of interest. Think of these as adding a turbo charger to the theme. Following the smallest of small, the PowerShares Zack's Micro Cap (NYSE:PZI) tracks 401 micro-cap stocks including automotive service station operator Pep Boys (NYSE:PBY) and steel producer Olympic Steel (Nasdaq:ZEUS).

Finally, for those investors who want to add active management in selecting the best small caps, no one does it better than Royce Associates. The firm is dedicated to small caps and several mutual funds specializing in them. Trading at nearly 15% discount to net asset value (NAV), the Royce Value Trust (NYSE:RVT) is one of its better choices. The CEF has managed to outperform the Russell since inception in 1986. Investors with $10,000 in the fund at inception would have an extra $37,000 today if they went with the actively-managed Royce fund versus the index.

Bottom Line
Small caps might be just what a portfolio is looking for. If the economy to returns to some level of normalcy and banks begin to lend again, we will see their share prices continue their upwards trend. However, the sector also performs quite well in secular bear markets. Due to the uncertain nature of the next few months, investors may want to add a broad small cap fund to their portfolio such as the Vanguard Small Cap ETF (NYSE: VB) to benefit from these trends. (For related reading, take a look at Introduction to Small Caps.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  2. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  3. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  4. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  5. Investing Basics

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  6. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  7. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  8. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  9. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  10. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!