After years of positive returns, the Australian small ordinaries index had a rocky 2018.
The index fell 8.7 per cent overall, with the most volatility occurring in the final three months of 2018. In the December quarter, the small ordinaries plunged 14 per cent.

However, this year has so far been a different story: in the first three months of 2019, the market has bounced back strongly. Several stocks are shining, including logistics software maker WiseTech Global (ASX: WTC), up 45 per cent, and fintech Afterpay Touch Group (ASX: APT), up more than 65 per cent.

We’re not suggesting everyone adds a small-cap fund to their portfolios. But if you are seeking small-cap exposure, there are some names to consider.

We've asked Ross Macmillan, senior analyst for Morningstar Manager Research, for his three top fund picks in the domestic equity small-cap segment. All three were finalists at the Morningstar Fund Manager of the Year awards, with Fidelity Future Leaders Fund taking top spot for the second year running. Following are some Morningstar analyst thoughts on the funds:

Colonial First State Australian Small Companies Fund (7006)

"CFS Wholesale Australian Small Companies remains an excellent choice for investors looking for domestic small-cap exposure. An experienced and skilful team led by senior portfolio manager Dawn Kanelleas backs this strategy. Kanelleas has been solely accountable here since July 2014 following the retirement of her long-serving comanager Peter McGann, and she is well supported by tenured CFS staff Michael Joukhador and Pavlos Totsis. The pair were rightly promoted to portfolio managers in 2014. In our view: all three demonstrate strong insights across the small-cap market, and the team works well together. Importantly, this fund separated from its large-cap cousin, CFS Australian Equities Large Cap Core, in mid-2016, resulting in a far more autonomous structure, including the benefits of performance incentives. This was a big step forward in the alignment of unitholders' interests with that of the investment team.

"The underlying process hasn't changed much since inception but has evolved under Kanelleas' leadership. The focus remains on unearthing companies with sustainable competitive advantages, but the emphasis on balance-sheet strength and cash flow has increased. Pleasingly, this enhances the quality aspect of the strategy, which we think is useful in the small-cap space. The portfolio is well-diversified across all sectors typically with 40-60 names (pleasingly, down from 70-80 in 2012). With a marginal growth tilt, there is a healthy mix of names across the value-growth spectrum.

"Impressively, this strategy has delivered strong returns through different market conditions, a testament to the team’s focus on quality businesses. A flat fee of 1.11 per cent adds appeal here. The lack of a performance fee is unusual in this sector and makes it very attractive on a total-cost basis. Assets have swelled to around $1.3 billion (May 2018), close to its estimated capacity. The fund is closed to new institutional mandates, but this remains a watchpoint.

"An insightful and motivated team applies a strong process that makes this fund a standout strategy in the domestic small-cap space." (Anshula Venkataraman)

Fidelity Future Leaders Fund (19893)

"An agile but rigorous investment approach applied by an insightful portfolio manager allows Fidelity Future Leaders to stand out from competitors.

"Fidelity has no distinct house investment style, apart from focusing on bottom-up fundamental stock research, with portfolio managers developing their own philosophy. As portfolio manager of this strategy, since inception in 2013, James Abela has established a well-structured and highly competent investment approach. However, the strategy's success is highly dependent on Abela's decisions, abilities, and skill, which is judicious, given the recent high turnover of analyst in the investment team. In the past few years, five members of the Sydney-based research analyst team and the director of research have departed. We view this level of turnover as too high. Ultimately, the team will improve with time and we continue to have considerable confidence in Abela, but we remain mildly concerned by the significant changes that have occurred.

"The process starts with the analysts who undertake detailed business assessment, extensive management meetings, in-depth industry reviews, and proprietary financial forecasting. Abela then screens the companies, based on the three pillars of viability, sustainability, and credibility, which have allowed him to avoid some of the major stock disasters of the past year. Portfolio construction is structured around quality, momentum, transition, and value. Abela alters the composition of these four segment weightings over time, within set ranges, which results in the portfolio tilting to growth or value, depending on financial market and economic conditions. Typically, the portfolio contains 40-70 stocks with turnover averaging between 60 per cent and 80 per cent per year. The strategy, based on three-year trailing returns to 30 June 2018, has materially outperformed most category peers and the index.

"Fidelity Future Leaders has numerous strengths including a thoughtful portfolio manager, well-considered investment process, and structured portfolio methodology, which should reward investors through the cycle." (Ross MacMillan)

Investors Mutual Smaller Companies Fund (5340)

"Investors Mutual Australian Smaller Companies is one of our favoured value style managers specialising in the small-cap space outside the ASX top 100. Portfolio Manager Simon Conn is an astute and experienced investor we hold in high regard. He has managed this fund since 2002, providing a level of continuity that is rare among peers.

"The strategy employs a disciplined investment process, seeking attractively priced investments that pass a strict quality filter to ensure the avoidance of ‘value traps’. The manager also prefers companies with earnings predictability, which results in heavy bias towards industrial stocks. Exposure to the oft-times speculative small-cap resources sector is generally limited to 5 per cent of the portfolio or less.

"This focus on value, quality, and predictability has stood the portfolio in good stead over the long term, enabling it to generate returns comfortably ahead of both the benchmark and peers over the 10 years to 30 June 2018. Recent times have been more of a challenge, particularly in the second half of 2017 when the portfolio’s underweighting to resources, absence of momentum-driven growth stocks, and a few painful stock-specific issues (downgrades from Mayne Pharma, HT&E, and Thorn Group) resulted in material short-term underperformance. In a broader market where returns have been dominated by a handful of high-P/E growth stocks, the underperformance of value is not unexpected. It is the stock-specific issues which are more disappointing, but we back Conn’s longer-term track record of stock selection, and we consider shorter-term issues to be an aberration. Importantly, the manager has remained consistent in its time-tested process, and the first half of 2018 has seen much better performance. Where this strategy has truly shone in the past is in falling markets, achieving a downside capture of just 39.9 per cent since inception. It is here we see considerable merit in utilising this fund to provide diversification to a broader equity portfolio. Investors Mutual Australian Smaller Companies remains one of our preferred small-cap managers in the value peer group." (Michael Malseed, senior analyst)