Note: Not sure when this was published....could be old, but some basic questions are answered regarding microcap definitions, etc.

Welcome to Net Gains, my exclusive online column. Every week, I'll answer your questions about investing.

Microcap madness

If you scan the weekly fund listings in USA TODAY (or virtually any newspaper), you’ll probably see a fund or a group of funds that catches your eye. Sometimes these are extremely interesting opportunities indeed. Other times, however, they are flukes that are best ignored. Let’s take a look at one such anomaly this week - the astonishing rise of microcap funds.

Microcap funds invest in stocks of exceptionally tiny companies - typically, those whose market capitalization is $300 million or less. Market capitalization is a stock’s current share price multiplied by the number of shares outstanding.

Recently, the microcap category has put up some astonishing numbers:

13 weeks: 13.8%

YTD: 21.1%

12 months: 23.5%

So what’s the story? The Russell 2000 index, which measures the performance of small-company stocks, has risen just 2.8% this year.

The main story is two funds, and the problems of average performance. So far, the Van Wagoner microcap fund is up 87% this year. And Blackrock microcap is up 64%.

The average performance in a mutual fund category is just that. Lipper takes the performance of all the funds in a particular category, adds them together, and divides by the number of funds in the category. Exclude Van Wagoner and Blackrock, and the average microcap is up 15% this year.

That’s still not a bad average. But there’s a wide diversity of performance among microcaps. The Perritt Capital Growth fund, for example, is down 10% this year. And Bridgeway Ultra-Small Company fund, an index fund, is up just 4.6%.

So what makes Van Wagoner so special, and many of the others so problematic? First, it’s a highly aggressive growth fund. Garrett Van Wagoner, the manager, trades at a dizzying pace. (He’s no relation to me.) He looks for companies with projected earnings growth of 20% or more, and has no particular problem with paying high prices for growth.

Nevertheless, the fund’s price to earnings ratio is 39.8 - higher than the Standard & Poor’s 500 stock index, but lower than one would expect, given Van Wagoner’s lust for growth stocks. In large part, that’s because many of his largest holdings have no earnings as yet. Remember, he looks for projected earnings growth, not actual growth. The fund’s largest holding as of the first of the year, Exodus Communications, had losses of $2.15 per share the past 12 months.

So should you invest in a microcap fund? Only if:

You can stomach very painful periods. Van Wagoner, for example, is coming off two years of steep losses.

You think the economy is in good shape, and should continue to be for some time. Very small companies are extremely sensitive to economic downturns.

You think interest rates will remain reasonably stable. Small companies tend to need a fair amount of short-term borrowing, and must rely on banks or venture capitalists for new money.

If you’re interested in small-company funds, here are the top five. Just make sure you don’t use the mortgage money for your initial investment.