NEW YORK (TheStreet) -- Micro-cap stocks have taken investors on a rough ride. In 2008, the Morgan Stanley Capital International U.S. Micro Cap Index dropped 44%, lagging the S&P 500 Index by 6 percentage points. The index has recovered this year, rising 38% and outpacing the S&P 500 by more than 25 percentage points.

The recent performance highlighted the appeal of these stocks, the smallest of the market. Although they can be extremely volatile, micro caps have outperformed the S&P 500 over long periods. During the 35 years ending in June, micro caps returned 14% annually, while large stocks returned 9.6%, according to Merrill Lynch, a unit of Bank of America.

Micro-cap stocks can help diversify portfolios because they don't always move in lockstep with the S&P 500. Adding a mutual fund that owns a mix of small and large stocks might help smooth out long-term results.

To appreciate the strengths and weaknesses of micro caps, consider the performance of the Wasatch Micro Cap Fund, which has soared in good years and collapsed in bad periods.

During the downturn that began in 2000, the fund shined. At the time, investors were dumping large technology stocks and shifting to small value names. With money gushing into micro caps, Wasatch returned 50% in 2001, outdoing the S&P 500 by 61 percentage points, according to Morningstar.

During the disastrous year of 2008, Wasatch lost 49%, trailing the S&P 500 by 12 points. For all the ups and downs, the fund boasts a strong long-term record, returning 12.0% annually during the past decade, outdoing the S&P 500 by 13 percentage points.

Definitions of micro caps vary. Some analysts limit the field to stocks with market capitalizations less than $500 million, while others consider the cut-off point to be $250 million. Perritt Capital Management includes the approximately 2,200 stocks that have capitalizations less than $450 million. The median capitalization of the group is $95 million.

By many measures the category is small, with a total market cap of around $300 billion, according to Perritt. In comparison, Exxon Mobil has a capitalization of $335 billion.

The small size helps explain why micro caps can be so volatile. If just a bit of money leaves the group, the shares can plummet. That happened last year when panicked investors dumped shakier micro caps and took refuge in Treasuries.

To hold micro caps, consider relying on a well-diversified fund. A top choice is the Royce Micro-Cap Fund, which has returned 12% annually during the past decade. The fund typically holds about 200 stocks and never puts more than 1.5% of assets in a single stock.

Royce & Associates looks for stocks with sound balance sheets, making them more resilient in economic downturns. The portfolio includes beaten down stocks along with companies with rapidly growing earnings. Morningstar often classifies it as a "blend" fund because it holds growth and value shares.

A favorite holding is The Buckle, a retailer of jeans and other casual apparel for young men and women. The company has remained profitable throughout the recession.

"This company has a solid balance sheet and a long track record for maintaining healthy returns on equity," says Royce portfolio manager Jennifer Taylor.

Another diversified fund is the Perritt Micro Cap Opportunities Fund, which has returned 11% annually during the past decade. The fund holds 120 names that have an average market cap of $128 million.

Portfolio manager Michael Corbett looks for companies that are improving their cash flow and profit margins, and cutting their debt. The fund holds some growth and value names. Most of the businesses focus on strong niches.

Corbett likes John B. Sanfilippo & Son, a supplier of peanuts, almonds and snacks. The stock is cheap and its sales will like remain steady, he says. "This company has almost $600 million in sales, but the market cap is only around $100 million," he says.

The Heartland Value Fund, which has returned 8.2% annually over the past decade, is another strong performer. Bill Nasgovitz, who has managed the fund since 1984, looks for stocks with strong balance sheets that have fallen out of favor. Lately, he has been focusing on stocks with price-to-earnings ratios less than 14. About one third of the portfolio's holdings have no debt, and most of the rest have very little.

The fund owns shares of Ensign Group, a nursing home operator. Although the company has been reporting double-digit sales and earnings gains, the stock sells for a modest price-to-earnings ratio of 10. "This is a leader in the business, but it has fallen out of favor because of the uncertainty surrounding health care," Nasgovitz says.

-- Reported by Stan Luxenberg in New York.