Should You Invest in a Small Cap Fund?

When investing in stocks, you may encounter small-cap, mid-cap and large-cap classifications. Small-cap growth funds focus on fast-growing smaller companies, while small-cap value funds invest in undervalued small firms that Wall Street has yet to recognize. These funds can offer benefits over mid- and large-cap options but may not suit every investor. Understanding their nuances can help you determine if they fit your portfolio strategy.

You may also want to work with a financial advisor to help you figure out which investments will help you reach your long-term financial goals.

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. mall-cap funds invest in companies with a relatively small market capitalization.

If you’re not already familiar with the concept, the term “small-cap” refers to companies that have a total market capitalization of $250 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 (META), 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

Small-cap funds offer unique investment opportunities for those seeking high-growth potential and diversification. While they come with higher volatility, their potential for strong gains and market inefficiencies make them attractive for investors willing to take on more risk. Here are some key reasons to consider investing in small-cap funds:

High growth potential: Smaller companies have more room for expansion, leading to faster revenue and earnings growth than established large-cap firms.

Market inefficiencies create opportunities: Small-cap stocks are often overlooked by institutional investors, allowing individuals to find undervalued stocks with strong upside potential.

Diversification benefits: Adding small-cap funds to a portfolio can help balance risk by spreading investments across different market segments and reducing reliance on large-cap stocks.

Potential for long-term gains: Historically, small-cap stocks have outperformed large-cap stocks over extended periods, making them attractive for investors with a longer time horizon.

Acquisition potential: Many small companies become acquisition targets for larger firms, leading to significant stock price appreciation when buyouts occur.

Resilience in economic recoveries: Small-cap stocks tend to rebound faster after economic downturns, as smaller businesses are often more agile and adaptable to changing conditions.
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.

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 a lengthy track record like the 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. However, 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 a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can 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.