How to make large gains from smaller companies with way less risk

Small-cap investing can be a very profitable strategy. Looking at my own portfolio, several smaller companies I own performed extremely well last year. For example, email specialist DotDigital Group rose from 58p to 105p, a gain of 80%. Similarly, big data group First Derivatives climbed from 2,125p to 4,180p, a gain of 97%. These kinds of gains can increase your wealth at a fast pace.

However, the drawback to small-cap shares is that they are considerably more risky than larger companies. That's because their share prices tend to be a lot more volatile than the share prices of blue-chip companies. It's not uncommon for a smaller company to see its share price fall 20% or even 30% in the space of a few trading sessions. Look at Boohoo.Com. In late September last year, the shares were changing hands for almost 270p. A week later they were trading at 190p. That's a 30% decline in the blink of an eye. Similarly, IQE has fallen from 180p in November, to around 123p today, a drop of 30%.

Big losses can destroy your wealth. After all, if one of your holdings falls 50%, you need a 100% return to break even. If a stock falls 80%, you need a 400% return to get back to square one.

Is there a way to enjoy big profits from smaller companies with less risk? Yes there is. Take a look at small-cap mutual funds.

Diversify your capital

Small-cap funds are an excellent way to add extra growth power to your portfolio, with less risk.

Because your capital is spread out over a whole portfolio of smaller growth stocks, it means that you're way less exposed to 'stock-specific' risk. That's the risk of one poor performing stock doing serious damage to your portfolio.

Of course, smaller companies as a whole can be out of favour at times. So you could still see your capital fall in value. However, over the long term, a portfolio of high-quality small-caps selected by a professional fund manager should perform well and outperform the FTSE 100 or a portfolio of large-cap stocks.

Top small-cap funds

There are plenty of small-cap funds listed on investment platforms such as Hargreaves Lansdown. So what are some of the best performing funds?

Over a three-year period, the Old Mutual UK Smaller Companies Focus fund has performed extremely well, returning 130%. In the last year alone, it returned 45% - around four times the return of the FTSE 100. Top holdings within this fund include Blue Prism Group, Fevertree Drinks and Alpha FX Group.

Another top option is the Jupiter UK Smaller Companies fund. This has returned 43% and 109% over one and three years respectively. The top three holdings here include Frontier Developments, Trupanion and Ocado Group.

Now obviously, past performance is no guarantee of future returns. Small-cap shares may continue to soar or they may lose their shine.

However, for investors interested in adding growth to their portfolios with less stock-specific risk, small-cap funds are generally an excellent way to profit from the stock market's smallest, most exciting growth companies.

Grow £1,000 to one million

Small-caps have the potential to dramatically increase your wealth over the long term. Even if you're only starting out with £1,000 today, who knows how much your portfolio could be worth in 10 years' time if you play your cards right?

With that in mind, if you're looking to maximise your investment returns, I'd highly recommend reading this exclusive report: 10 Steps to Making a Million in the Market.

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Edward Sheldon owns shares in DotDigital Group, First Derivatives and Boohoo.Com. The Motley Fool UK has recommended Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.