By Ben Baden

Large companies may occupy the limelight in your portfolio, but it's important that you also make room for mid- and small-cap stocks. These smaller companies, which include fast-growing businesses, can add a dose of risk and diversification to your investments.

"Over the very long term, the data has shown that small-cap stocks are more volatile and have gained more than large-cap stocks," says Morningstar fund analyst Greg Carlson. From January 1926 through November 2010, large-cap stocks have returned an annualized 10 percent, while small-cap stocks have gained an annualized 12 percent, according to Morningstar. Lately, the performance of small caps versus large caps has been even more pronounced. The average small-cap blend fund -- which invests in both value and growth stocks -- has returned 26 percent so far this year, on top of an average gain of 32 percent in 2009. The S&P 500, meanwhile, is up about 13 percent year-to-date and gained 26 percent in 2009. (In 2008, the S&P 500 and the average small-cap blend fund each lost 37 percent.)

Small-cap funds' relative outperformance in recent years has some prognosticators placing bets on a revival in shares of larger companies over the next few months since small-cap stocks generally lead the pack coming out of recessions, Carlson says. But he suggests maintaining a healthy allocation to smaller names as a part of a long-term diversified investing strategy.

When evaluating funds in this category, investors should pay attention to the portfolio's average market capitalization. That's because some managers focus on the tiniest companies -- called micro-caps -- while others may invest in anything that isn't considered a large-cap stock. The size of the fund -- in terms of assets -- is also important, because asset bloat can hinder a manager's ability to move in and out of positions. "Some funds get too big ... and they either move their market-cap emphasis upward, or sometimes they struggle a bit," Carlson says.

With that in mind, here are U.S. News's best small-cap blend funds for the long term:

Royce Micro-Cap (symbol RYOTX)

Because of its micro-cap focus, this fund can be quite volatile at times. In 2008, it plummeted more than 40 percent and landed near the bottom of its category. But from the market's low on March 6, 2009, to its most recent peak on April 23, 2010, the fund doubled in value, according to Morningstar. Although Royce Micro-Cap's main focus is U.S. stocks, management can invest a substantial amount of assets overseas. Almost a third of assets currently reside in foreign stocks, with a small portion in emerging markets like China and India. Over the past 10 years, the fund has returned an annualized 13 percent. Its annual fees are 1.54 percent.

Fidelity Small-Cap Stock (FSLCX)

Since Andy Sassine took the reins of this fund in July 2008, it has outperformed 85 percent of its category peers, according to Morningstar. In recent years, the fund's performance has been volatile. Its 43 percent loss in 2008 was among the steepest in its category, but a whopping 63 percent return in 2009 ranked it among the category's top performers. About 12 percent of the fund's total assets are invested outside of the United States, mostly in developed markets in Europe and Asia. Over the past 10 years, the fund has returned an annualized 9 percent. Its annual fees are 1.23 percent.

T. Rowe Price Small-Cap Stock (OTCFX)

In 2008, when many small-cap stocks took a huge beating, this fund fell 33 percent, 3 percentage points less than its average peer. It returned 39 percent in 2009 and is up another 23 percent so far this year, ranking it near the top of its category. Manager Greg McCrickard's buy-and-hold strategy is evident in the fund's low turnover ratio of 28 percent. The fund, which has returned an annualized 8 percent over the past 10 years, charges 0.95 percent in annual fees.

Royce Heritage (RGFAX)

Manager Chuck Royce invests in small companies throughout the world. Almost a third of the fund's total assets are invested abroad, including a 7 percent allocation to emerging markets. That foreign tilt helped Royce Heritage outperform its peers mightily in 2009, with a gain of 52 percent. The fund holds about 200 stocks, and its turnover ratio of 59 percent shows that Royce replaces his portfolio about every two years. Over the past 10 years, the fund has returned an annualized 11 percent. Its annual fees are 1.42 percent.

Tributary Small Company (FOSCX)

Previously known as First Focus Small Company, the fund was renamed Tributary Small Company in August 2010 following the consolidation of the fund's two advisers, Tributary Capital Management and FNB Fund Advisers. While most small-cap funds lost about 40 percent in 2008, this fund fell 25 percent. Management takes a long-term approach to investing, and tends to hold about 60 or 70 stocks for a period of about three to five years. The fund has returned an annualized 9 percent over the past 10 years, and its annual fees are 1.34 percent.

Lazard U.S. Small-Mid Cap Equity (LZSCX)

As its name suggests, management invests in a mix of small- and mid-cap stocks. Generally, mid-caps are companies with a market capitalization between $2 billion and $10 billion. The fund finished in the middle of the pack in 2008, but it came roaring back in 2009, returning 55 percent. Management is currently invested in about 80 stocks and is overweight in consumer goods and industrial materials companies. Over the past 10 years, the fund has returned an annualized 8 percent. Its annual fees are 1.51 percent.

Lord Abbett Small-Cap Value (LRSCX)

Despite its name, the fund holds many stocks with higher values that are often deemed "growth" rather than "value" stocks. Since Gerard Heffernan took over as manager of this fund in February 2009, it has generated middle-of-the-pack returns. It gained about 30 percent in 2009, and so far this year, it's up 16 percent. Currently, Heffernan is betting on an economic recovery in the United States with an overweight in industrial materials stocks. Over the past 10 years, the fund has returned an annualized 12 percent. Its annual fees are 1.24 percent.

Royce Pennsylvania Mutual (PENNX)

This fund, which invests in small- and micro-cap stocks, is an "all-weather vehicle," according to Morningstar. Its rather expansive portfolio of more than 400 stocks helps keep volatility lower than that of its peers. After finishing among the top half of its category in 2008, the fund returned 36 percent in 2009, ranking it in the top quarter of the category. It has returned an annualized 11 percent over the past decade. Annual fees are 0.92 percent.

FMI Focus (FMIOX)

Recently, the fund has outperformed its peers in bear markets as well as bull markets. In 2008, it lost 30 percent -- 7 percentage points less than its average peer -- and in 2009 it rallied with a 40 percent gain. But the fund's 7 percent annualized return over the past decade lands it closer to the category average. FMI Focus generally holds about 60 to 70 small- and mid-cap stocks. Generally, management replaces the entire portfolio about every two years. Annual fees are 1.30 percent.

Neuberger Berman Genesis (NBGNX)

In January 2008, this fund reopened to new investors after being closed for seven years. Management focuses on established companies generating strong cash flows. That means when more speculative stocks rally, this fund will lag its peers, as it did in 2009 and 2010. The fund currently holds more than 100 stocks and has a low turnover ratio of only 16 percent. Over the past 10 years, it has returned an annualized 11 percent. Annual fees are 1.06 percent.

 

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