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.)


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