Should the stock market turn solidly bullish, small-cap stocks could be poised for good returns. But small caps are generally more volatile and less widely analyzed than large-cap stocks, making some planners and their clients leery of the sector. Craig Hodges, portfolio manager of the Hodges Small Cap Fund, talked to Financial Planning about his views on where small caps are going and how advisors might approach investing in them:

Q. Small caps underperformed their larger cap peers in 2011. What do you expect for small caps in 2012?

Larger cap equities outperformed in 2011 as this group played catch-up to the performance that small and mid-cap stocks experienced in the previous two years.  This also resulted from a lower risk appetite in 2011 that stemmed from investor uncertainty and skepticism.  This held back many of the industrial and cyclical sectors of the market, while more defensive areas like healthcare, consumer staples, and utilities turned out to be the best performing sectors.

This year, we believe small caps offer investors opportunities to participate in unique pockets of growth and are not contingent on the global macro environment.  Furthermore, large cash balances on corporate balance sheets should continue to facilitate merger and acquisition activity in 2012, as larger companies buy smaller companies in an effort to accelerate their own growth after under-investing in organic opportunities during the recession.    

I also suggest looking at the Russell 2000 compared to the one and 10-year returns on the S&P 500.  The total return on the Russell 2000 in 2011 was 4.15% compared to a total return of 2.1% for the S&P 500 index.  Over the past ten years, the Russell 2000 has had an annualized return of 5.6% compared to 2.9% for the S&P 500.   We have also looked at Ibbotson data that shows small caps outperform large-cap companies over long periods of time.   For instance, small-cap stocks have outperformed large-cap companies by over 20% from 1928 through 2009.

Q. Why should advisors allocate to small caps? What are the compelling characteristics and what are the risks?

Large-cap companies are fairly well covered by numerous financial analysts, while there are typically fewer analysts that cover small-cap companies. This creates a huge opportunity for active money managers and investors that are able to perform in-depth research.

Less liquidity in small caps can be an advantage. Because small-cap companies are generally thinly traded, they tend to respond more dramatically to company-specific news, which can often reward proprietary research efforts that anticipates such events.  Furthermore, less liquidity translates into the greater the likelihood of inefficiencies and disparities that can be taken advantage of by active managers.

Q. How should advisors go about evaluating a small cap fund?

One of the most important elements for investors (and their advisors) to consider is that small-cap investing is generally more risky.  As a result, investors should carefully consider their investment horizon, risk tolerance, and investment objectives when determining an appropriate allocation to small cap stocks.  Nevertheless, a greater degree of risk commands the potential for greater returns. As a result, small caps tend to be more volatile, and outperform larger cap stocks over longer periods of time.  Small cap funds generally command higher expenses due to the intensive research efforts that are required to generate above average returns in these funds.

As for evaluating a fund, it is obviously important to look at tenure of management and investing philosophy.  Since the advantage in small caps comes from in-depth research, we believe the long-term advantage goes to those funds that use a bottom-up strategy.  Furthermore, the nature of investing in companies with small capitalizations creates a natural capacity constraint, which we believe gives an advantage to smaller funds with less than $1 billion of assets under management.  Once a small-cap fund gets over $1 billion in assets, it eliminates certain opportunities and often is forced to dilute the number and size of its holdings.  For this reason many top-performing small-cap funds are closed once they hit a certain asset size.

Danielle Reed writes for Financial Planning.