The global economy remains weak, as Europe continues to work its way through recession and China backs off from the blistering growth rates of the past two decades.

Here in the US, however, things are on an uptick. The housing sector is returning to health as both home prices and construction pick up. The employment outlook has also been steadily improving, albeit slowly, with thousands more Americans returning to work each month.

Because of the divergence in economic growth—here vs. abroad—investing in US multinational companies has gotten trickier. While their earnings have held up relatively well, US-based multinationals typically derive about a third of their revenue outside the US. Because of this, they have faced headwinds that are creating a drag on their stock valuations.

In the meantime, US small-cap stocks have become increasingly attractive. Typically deriving less than 20 percent of their revenue outside the US, smaller companies are much more leveraged to the domestic economy. It’s not surprising then that the leading index of US small stocks—the Russell 2000—is up 23 percent so far this year, zipping past the multinationally laden S&P 500, which is up close to 20 percent.

Another plus is that smaller companies aren’t as dependent on US economic growth in general. While the giant companies hope for GDP growth in order to enlarge their markets, smaller companies can create their own books of business by undercutting their larger peers on price or through innovation. And given that they’re starting from a smaller base, smaller companies don’t need large absolute gains to produce strong earnings growth.

Finally, small companies typically have limited access to debt markets; they’re mostly equity financed. So they’re not as affected by an increase in interest rates.

Still, small-cap stocks do carry their own unique risks, such as reduced access to credit, dependence on a smaller customer base and more volatile earnings. Such risks can be overcome by holding a diversified basket of names, making exchange- traded funds (ETFs) an ideal investment vehicle for this asset class.

Small and Feisty

Vanguard Small Cap Fund (NYSE: VB) replicates the CRSP US Small Cap Index and holds about 1,400 small stocks, representing about 13 percent of the US equity market.

Assets are divided across a wide array of industries. The top five sector allocations are: industrials (18 percent), consumer cyclical (15 percent), technology (14 percent), financials (12 percent) and real estate (11 percent).

Thanks to its blend of growth and value stocks, VB tends to hold up relatively well throughout various points in the business cycle, and typically outperforms during downturns.

While we don’t foresee another big recession in the near future, it’s good to pay attention to the potential downside. During 2008, VB was down about 36 percent, in line with the S&P 500.

Also keep in mind that while small US stocks have outperformed large equities over time, they sport higher valuations and price volatility than the biggies.

So it’s important not to overweight small stocks in your portfolio. Typically, an allocation of 10 to 20 percent is considered sufficient exposure, depending on your age and financial circumstances.