Investors should be looking to hold small- and mid-cap US equities, as they traditionally benefit from cyclical upturns, are more likely to be affected by price anomalies and diversify risks, says David Wagner, a portfolio manager of such equities at T Rowe Price.

The US smaller companies equity fund managed by Mr Wagner returned just under 36 per cent according to its year to date figures released on 30^th September, compared with an increase of approximately 28 per cent in the Russell 2500 index.

Mr Wagner’s argument is based upon the assumption that the US economy has reached a turning point and will improve. He uses historical data going back to 1926 to show that small- and mid- cap asset classes have benefited from cyclical upturns and often rally after increases in M&A activity; conditions recently seen in the market.

The data also shows that in the past investors who were exposed to the asset classes for long periods of time were rewarded, with annualised returns above those for large-caps.

The recent high volatility in financial markets means investor sentiment has outweighed other drivers of returns, such as earnings, in driving asset prices. A loss in investor confidence affects small-caps relatively more than other stocks, as they are less liquid and higher risk, he notes.

Mr Wagner says therefore the normalisation of conditions will benefit these asset classes.

Current price/earnings ratios are higher for small-caps than large-caps, but Mr Wagner says he expects this to be corrected in 2010 and is due to recent weak earnings growth in the area.

Mr Wagner says the opportunity sets of the asset classes are larger than generally perceived, and that they operate in a less efficient space than large-cap companies. This creates opportunities from pricing anomalies, but means that bottom-up research and active management are important for success when investing in these asset classes.

Small-cap companies can deliver high returns as they include companies in their high growth phase and companies which can quickly adapt to new technologies and market conditions, Mr Wagner says. He advises holding a small- and mid-cap portfolio to capture the benefits of high growth companies without having to sell them off when they reach an arbitrary market cap value.

Small- and mid-cap equities can also offer diversification to a portfolio containing large-cap equities, as environments favouring one may not favour the other, says Mr Wagner.