In the world of investing, it's generally accepted wisdom that large-cap stocks are relatively safe and small-cap stocks are volatile and risky. Many advisors in the bank channel consider small caps too risky for most client portfolios. Yet the fact is that small caps have outperformed large caps for the past decade and, as they usually do, have been leading the economy out of the recession. Maybe it's time to reconsider a permanent allocation to this asset class.

Even though investors dumped small-cap stocks in droves during the two major recessions of this past decade, small caps outperformed mid and large caps during the whole troubled period. Analysts are calling 2000-2010 the "lost decade," because the S&P actually showed an average loss of -1% per year, and was still slightly in the red, even when dividends are factored in.

But it wasn't a lost decade for small-cap stocks. The Russell 2000 Index of small-cap stocks had an annualized average gain of 3% per year over the same period. Jonathan Rahbar, an analyst with Morningstar, notes that, in fairness, if you look at a 15-year period, going back to 1995, the Russell only outperformed the S&P by 50 basis points per year, instead of 400, but it still outperformed. So advisors might want to consider allocating a portion of clients' equity portfolios to small caps. And if your clients don't own small caps, this could be a good time to get into the asset class. While they performed fabulously in the past year, they've still got a way to go.

"What has been amazing to me, looking back at this whole period, is that even when the market has gotten hit, small caps have held up pretty well," says Douglas Cote, senior market strategist and senior vice president of ING Investment Management in New York City. "Typically in the bank channel, you have a lot of investors who don't even own small caps. So my advice to financial advisors at banks is: If your clients don't have small caps in their portfolios, they should. Every portfolio should have exposure to small caps, for both return and for risk control reasons."

ON THE REBOUND
There's another reason to own small caps now, because they are generally the first to rebound when a recession ends and a bull market begins. The economy is crawling out of the deepest and longest recession since the 1930s, and small caps have delivered stellar returns since the markets turned around. From March 2009 to May 2010, while the S&P Index rose 61%, the Russell 2000 rose by a startling 91%. The small-fry did the same for the first half of the decade, outperforming large caps through the tech wreck of 2000 to 2006. Over the past year, despite a dip over the European crisis, the Russell is up 21.48% versus a 14.43% gain for the S&P.

"Small cap stocks do outperform large caps, especially at the start of a recovery," says Morningstar's Rahbar. "Typically, they get beaten up in a recession, when credit gets tight and large firms have more access to capital. Then, when you have a recovery, small caps will rise earlier and by more than large caps."

That's because the weakest companies have been weeded out, leaving only stronger firms, says ING's Cotes. And "in a recovery you are getting a lot of bottom and topline growth, and small-cap companies have relatively low fixed costs compared with revenues and earnings. They are also more nimble and can adapt to competitive threats and opportunities and introduce new products more quickly." In addition, investors coming out of a recession are increasing their risk tolerance, so there is more demand for small-cap stocks, he says.

Take some of Morningstar analysts' top fund picks in the category: the Royce Special Equity Fund, the Wasatch Small Cap Fund and the Vanguard Tax Managed Small Cap Fund. The Royce Special Equity Fund (RYSEX), with $1.5 billion under management and 83 holdings, was up 0.86% year-to-date as of July 14, and 16.3% for the 12-month period ended March 31. Over the past 10 years, the fund had an average annualized gain of 11.4%. The Wasatch Small Cap Fund (WAAEX) as of July 14 was up 2.32%, and was up 19.2% for the previous 12 months. Over 10 years, it has shown annualized gains of 5.7%. The Vanguard Tax Managed Small Cap Fund (VTMSX) is up 4.5% year-to-date as of July 14. For the prior year it has gained 25.23%, and its 10-year annualized gain has been 6.14%.