Don't Miss the Next Mega-Cap Rally

In many ways, this year's market represents a dramatic reversal. After three brutal years, stocks are enjoying a great run and bonds are flat. Yet one thing has remained the same: Small caps are whipping large caps.

For the year to date, the Morningstar Small Cap Index is up 34% versus 17% for the Morningstar Large Cap Index. In fact, large caps haven't beaten small caps since 1998. The trailing five-year returns show just how wide the gap has become: The Morningstar Small Cap Index is up an annualized 9.51% while the Morningstar Large Cap Index is down an annualized 1.19% over the last five years.

Before the small-cap run started, I remember getting awfully sick of repeatedly pointing out that small caps were bound to make up ground on large caps eventually. I probably started saying that in 1996 or 1997, but large caps just kept on chugging, leading Bob Markman to declare in 1999 that large growth was all anyone needed. Whether it's large caps versus small, or growth versus value, streaks of outperformance by one group over the other often last a long enough to make you wonder if the underdog will ever recover.

One reason for the extended periods of lopsided market returns is that macroeconomic trends may start to favor one class over another. In the 1990s, large caps were particularly strong because downsizing and productivity gains enabled big companies to grow at a rapid clip. But beyond the reality of macro trends, market psychology leads us to exaggerate these trends because we have a bad habit of taking recent trends and extrapolating them to absurd places. So, maybe small caps have more room to run. Market technicians often talk about seven-year cycles for small caps, and we've got a few years before the small-cap rally hits that milestone.

However, at some point in the future giant companies figure to enjoy a decent run again. And because the vast majority of stock funds have average market caps below the S&P 500, it's quite possible you could miss out on such a rally. You don't necessarily need to have a lot of mega-cap exposure. Bill Miller of  Legg Mason Value (LMVTX) says the best opportunities are usually in the smaller end of large caps. But, I don't think it makes sense to go entirely without some exposure to mega-caps.

Fortunately, there are some good options to add mega-cap exposure to your portfolio. The obvious way is simply to buy an S&P 500 fund like  Vanguard 500 Index (VFINX). There are also some excellent actively managed funds that tend to favor the giants. I screened for three that have average market caps greater than or equal to the S&P 500 and chose three of the best:

 ABN AMRO/Montag & Caldwell Growth  (MCGFX)
Catchy name isn't it? Fortunately for shareholders, the strategy isn't trendy either. For many years manager Ron Canakaris has looked for companies growing at double-digit growth rates whose shares are trading at a 20% discount to his intrinsic value estimate. So, you'll find names like  Coca-Cola (KO),  Pfizer (PFE), and  Procter & Gamble (PG) in the portfolio. Over the years, Canakaris has produced solid returns with such names.

 Dreyfus Appreciation (DGAGX)
Most of those same things could be said about this fund. Subadvisor Fayez Sarofim likes brand names at reasonable prices, and the managers are quite patient with their picks. Both funds also held up better than other large-growth funds in the bear market but have lagged in this year's rally because they have light weightings in tech.

 Fidelity Dividend Growth (FDGFX)
Manager Charles Mangum is one of a number of Fidelity managers who use a counterpunching growth strategy. It makes sense to take what the market gives you when you manage as much money as Fidelity does. For example, he earned a nice return by buying battered investment bank stocks during the bear market.