SOMETIMES, smaller can be better. This is a concept investors in the United States have adopted over the past three decades because the returns of smaller capitalised companies have generally been outperforming their larger counterparts. According to Chicago-based investment-consulting firm Ibbotson Associates, US$1 invested in a typical small US stock from December 1925 to June 1993 increased to $2,424.68, while $1 invested in a large stock grew to $762.45. ''Depending on the investor, if there is a role for equities in a portfolio, there is a role for small companies,'' said Keith Getsinger, a senior consultant at Ibbotson. ''There is terrific return potential but more risk. Investors need to be aware of the fact they are a long-term plan. Small companies are a big roller-coaster and you don't get big upside without some downside.'' In Hong Kong, the small company investment story has only recently started to attract serious attention as investors, who basked in the glow of higher blue chip stock prices last year, have begun to look for new vehicles that offer high returns. If investors needed evidence of such potential gains, the 208.6 per cent jump posted by Jardine Fleming's Eastern Smaller Companies Trust and the 125 per cent rise of GT Management's Asian Small Companies Fund were sufficient. And with an increasing number of US investment houses which have extensive experience of investing in small companies establishing offices in Hong Kong, interest among investors is bound to grow. Among the benefits offered by small companies are that they are easier to understand, provide portfolio diversification and reduce risk, because their performance has a low correlation with larger capitalised stocks. Apart from Jardine Fleming and GT Management, other investment firms offering small company mutual funds are Schroders Asia Unit Trust and Credit Lyonnais International Asset Management. Crosby Securities (Hong Kong) has also placed increased emphasis on the sector by applying more research resources. It now has six analysts closely covering a portfolio of 120 companies in the territory. In January, Crosby issued its first overview on smaller companies, called How to Benefit from Hong Kong's Small Cap Effect, and made presentations to institutional clients in London and New York. Rothschild Asset Management plans to join the fray this month by launching a fund for its institutional clients. As part of the Five Arrows Asia Pacific Fund, it will have a mandate to invest in mainly non-index stocks in Asian markets from South Korea to Pakistan. It will have a launch price of US$10 a unit. Many investors are being drawn to smaller companies because they have proved more resilient during the recent corrections that have hammered most markets. Robert Brewis, who manages Credit Lyonnais' Asian Smaller Companies Fund, said his $10 million fund was down only seven per cent this year, compared with the drops of more than 20 per cent in most Southeast Asian stock markets. He said small company stocks had posted modest declines because last year's liquidity-driven bull market had little effect on their prices - most capital was focused on liquid blue chip counters. As a result, he said small stocks still offered good value and higher growth potential than the blue chip stocks that soared to record highs. Raymond Hood, who is to manage Rothschild's fund, added that over the past two years small companies had lagged behind but were now attractive in terms of price-earnings multiples, yields and earnings prospects. ''We think over the next two to three years, well-selected small company funds will outperform blue chip stocks,'' he said. ''We are seeing a real look for new avenues of value.'' One of the biggest challenges facing analysts and fund managers covering small companies in Asia is their large number, which is growing at a rapid rate as firms come to the market to support fast growth. Mr Hood said many small firms were trading at low price-earnings multiples because they were under-researched, providing analysts and fund managers with great opportunities to root out bargains. To determine whether a smaller company was prime for investment, fund managers had to conduct substantial independent research - a time-consuming process that required constant updating. Mr Hood said he focused on the fundamentals of a company's business, such as margins, strength of management, how controlling shareholders were compensated, and competition within the sector. He said this approach was quite eclectic, involving everything from computerised searches and meetings with management to conversations with contacts and competitors. ''I've lived in Asia a long time and have a wide range of friends. They often give me ideas,'' he said. James Alexandroff, who manages the $170 million open-ended GT Asian Small Companies Fund, agreed that research remained an obstacle facing investors looking at small firms. He said this was routinely caused by the fact that responsibility for coverage often landed in the lap of junior or inexperienced analysts; a practice that provided marginal benefits. With more than 2,500 small companies in Asia, excluding Japan, including about 80 per cent with market capitalisations of less than $250 million, stock selection could be a daunting task. Mr Alexandroff said the key was to sift through companies, avoiding those that showed signs of remaining small and did not have long-term prospects, and focus on those with the potential to eventually grow into large corporations. Given this strict criteria, Mr Alexandroff estimated there were about 100 to 200 attractive companies in his investment universe. Mr Brewis said strong management was also an important factor because small companies lacked a long-term track record and, as a result, were riskier investments.