SMALL-CAP STOCKS generally outperform when interest rates are low, which isn't exactly reassuring in a year when the Federal Reserve is expected to raise rates a few times. Fortunately, where small caps are concerned, interest rates aren't the only thing to consider.

The small-cap market is generally defined as the smallest 10 percent of stocks, says Eric D. Nelson, a certified financial analyst and managing principal of Servo Wealth Management in Oklahoma City. Although rising rates can be a drag, small-cap stocks will be one of the biggest beneficiaries of the tax code changes this year and have had some of the biggest positive earnings since December, says Sean Lynch, managing director of equity strategies for Wells Fargo Private Bank in Omaha, Nebraska.

This asset class also supplies essential growth to any portfolio. From 1926 through 2016, small-cap stocks returned an average of 12 percent annually, versus 10 percent for large-cap stocks, says Robert R. Johnson, co-author of "Invest with the Fed" and a principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.

Since 1966, in years when rates were falling, small caps averaged returns of 28.4 percent annually while large-cap stocks returned 14.4 percent, Johnson says. But in years when the Fed raised rates – as it is doing now – small-cap stocks trailed large-cap stocks and returned only 5.2 percent annually, versus 5.7 percent for large caps, Johnson says.

Throw in greater volatility (small caps have an annual standard deviation averaging 32 percent, versus 20 percent for large caps, Johnson says), and clearly, investors have to step up their game to invest in smaller companies. These tips will help you spot strong small-cap investments.

Check the fund's turnover ratio. The turnover ratio tells you how frequently holdings in the fund are traded. We "target a turnover ratio lower than the median ratio for the small-cap asset class," says Paul Lightfoot, a certified financial planner and president of Optima Asset Management in Dallas. "Higher turnover ratios lead to higher trading costs and are generally less tax efficient." Lightfoot also suggests investing in funds with at least three years of performance history so that you can get an accurate idea of how often investments turn over.

Invest in sectors that will benefit from rising interest rates. The best-performing sectors when rates are rising are energy, utilities, consumer goods and foods. "People need to eat, put gas in their cars, brush their teeth and heat their homes regardless of the direction of interest rates," Johnson says. The worst-performing sectors are autos, durable goods, retail and apparel. Make sure the small-cap funds you're investing in are diversified across different sectors, Lightfoot adds.

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