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When choosing which stocks to invest in, you may run into these terms: small-cap, mid-cap and large-cap. A small-cap growth fund invests in smaller companies whose share prices are growing steadily. A small-cap value fund invests in smaller companies deemed to have underlying value that Wall Street has yet to recognize. Both types of small-cap funds can offer advantages over mid-cap or large-cap funds, but they may not be right for every investor. Getting to know the finer points of how these funds work can help you decide if investing in them is the right move to make in your portfolio.

What Are Small-Cap Funds?

Mutual and exchange-traded (ETF) funds can hold a collection of different investments, including stocks, bonds and cash. A small-cap fund focuses mainly on investments in small-cap stocks.

If you’re not already familiar with the concept, the term “small-cap” refers to companies that have a total market capitalization of $300 million to $2 billion. Market capitalization is a way to measure the total value of a company’s outstanding shares in the stock market. It’s determined by multiplying the total number of shares issued by a company by the market price of a single share.

Some examples of small-cap companies are First Bancorp (FBNC) and Bellicum Pharmaceuticals (BLCM). While the names of small-cap companies may not be as recognizable as some mid- or large-cap companies, such as Amazon (AMZN) or Facebook (FB), they can play a valuable role in a portfolio.

Small-cap growth funds give you exposure to these investments and their associated benefits in a single vehicle. Instead of buying individual shares of small-cap companies, you can invest in multiple companies through a single mutual fund, index fund or ETF. Small-cap index funds attempt to match the performance of a small-cap stock index, such as the Russell 2000 Index, which includes the bottom 2,000 stocks of the Russell 3000 Index. A small-cap ETF is a fund that trades on an exchange just like a stock.

Reasons to Invest In Small-Cap Funds

There are several features of small-cap funds that make them an attractive investment option, compared to their mid-cap or large-cap counterparts.

  • Performance. Small-cap stocks and small-cap growth funds are in a position to outperform mid- or large-cap funds for one very important reason: smaller companies have more room to grow. A large-cap or blue chip fund that focuses solely on big, established companies can still do well, but those companies may be expanding at a slower rate. Small caps, on the other hand, can grow at a faster pace, which can in turn yield better returns for investors who bought before the price rose.
  • Lower barriers to entry. Investing in small caps and small-cap funds may be more accessible for the investor who doesn’t have a lot of money to tie up or who wants to spread their investment dollars around. That’s because these companies and funds tend to be overshadowed by mid-cap and large-cap options so they don’t attract as much attention from larger institutional investors. This can help keep the initial cost to purchase shares relatively low and keep prices from inflating too quickly over time.
  • Diversification. A diversified portfolio matters for two reasons. First, diversification helps to manage risk when your investment dollars are spread across different asset classes. And second, it’s a way to boost your portfolio’s performance. If your investment strategy is dominated by mid-cap or large-cap stocks and funds, then adding some small-cap funds into the mix could help to boost your overall returns, while mitigating risk.
  • Durability. Many, though not all, small-cap funds include stocks that are essential to keeping the economy running smoothly, no matter in what cycle the economy is. That includes stocks that represent consumer staples, discretionary spending, healthcare, infrastructure and financials. Some small-cap funds can be considered defensive positions in that they can better withstand economic pressures compared to mid- or large-caps during a recession or periods of stock market volatility.
  • Valuation. If you rely on a value investing strategy, small-cap value funds could be just what you’re looking for. These funds focus on investments in small-cap companies that are considered to be undervalued. If you invest in one of these funds and the company takes off, then you could reap significant benefits from price appreciation of your shares.

Are There Any Downsides to Small-Cap Funds?

Small-cap funds do have a few potential drawbacks to keep in mind, most notably their tendency to be more volatile compared to mid- and large-cap funds. Because many small-cap companies are still finding their bearings, that can make them more susceptible to changes in business direction or mission, which, in turn, can affect share prices. It’s also possible that attempting to be innovative can get the best of a small-cap company if a new product line it’s developing flops or an updated marketing strategy is a strikeout.

Small-cap funds can also be riskier simply because these are newer companies that don’t have the lengthy track record that mid- or large-caps possess. An up-and-coming company that may be considered the next big thing can just as easily be left in the dust by another company with a similar product or service. The domination of Facebook and the demise of MySpace is a good analogy for how small caps can appear strong but be fragile in reality.

Should You Invest In a Small Cap Fund?

Whether it makes sense for you to invest in small-cap mutual funds or ETFs depends largely on how much risk you’re comfortable taking on, your overall investment style, risk tolerance, time horizon and goals.

If you’re interested in generating dividend income, for instance, a small-cap fund may not be the best fit. Many small-cap companies tend to reinvest available cash rather than make periodic payments to investors.

You may also want to steer clear of small-cap funds if you’re not as comfortable with potentially volatile investments. Small-cap stocks and their respective funds can experience substantial price swings. If you’re committed to investing in small caps for the long term, this may not be an issue. But if you’re focused on short-term capital appreciation, then watching prices move up and down could be nerve-wracking.

Bottom Line

A small-cap growth fund could add diversification to your portfolio if you lean more heavily on investments in mid-size or large-cap companies. A small-cap fund can be a strong performer, but it’s important to dig deeper to make sure a particular fund is the right choice. Consider the fund’s expense ratio, performance, investment strategy and asset holdings before making a final decision on whether to buy in.

Tips for Investing

  • Consider talking to a financial advisor about whether investing in a small-cap growth fund will advance your financial goals. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Think about whether you’re more interested in value or growth as an investor. Some small-cap funds are value funds, meaning they invest in companies that are undervalued and may experience significant price appreciation over time. Others are small-cap growth funds, which means they invest in small-cap companies that are growing at a faster rate than the rest of the stock market. Value investing tends to be more of a long-term, buy-and-hold play while growth investing is all about increasing your capital through investments in growth stocks.

Photo credit: ©iStock.com/Rawpixel, ©iStock.com/Drazen Zigic, ©iStock.com/andresr

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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