Mutual funds seek to align strategies with specific market segments, outlined for investors in the fund's prospectus. Many popular funds focus on a broad index, such as the SP-500 or Russell-2000, while others concentrate on income, sector or market capitalization. Capitalization funds work especially well with targeted holding periods because long-term market behavior tends to track specific capitalization levels, whether small cap, mid cap, or large cap.
Market capitalization has aligned with annual performance in a logical manner since the 2009 bear market low, using Standard and Poor’s indices as benchmark tools. The SP-100 large cap index posted a 373% gain from that low to the last trading day of 2017 while the SP-500 blue chip index rose 401%. The lower half of the capitalization spectrum outperformed those indices by a wide margin, with the SP-400 mid cap index gaining 478% while the SP-500 small cap index led all other rankings, with an impressive 513%.
Those tiered results, favoring small and mid cap over mega cap and blue chips, follow a trend going back to the start of the century and may continue into the next decade. As a result, prospective investors need a strong understanding of market capitalization to choose funds that offer the greatest upside potential. In this regard, let’s examine characteristics of capitalization-based mutual funds and potential returns from these instruments based on historical data.
A mutual fund categorized by market cap (i.e., small cap, mid cap or large cap) indicates the size of the companies in which the fund invests, not the size of the mutual fund. Market cap is calculated by the number of shares outstanding, multiplied by the current market price of one share. Thus, a company with one million shares outstanding, selling at $100 per share, would carry a $100 million market cap.
Small cap funds typically include companies with market caps of less than $2 billion. However, the dividing line can change and exact definitions can vary between funds and brokerage houses. Generally speaking, smaller companies are engaged in the early stages of business operations. They’re presumed to have significant growth potential but aren’t as financially stable or established as larger companies. Many mutual funds cannot take large positions in small cap stocks without filing with the SEC, which has the added benefit of greater transparency.
Small cap funds can be volatile because they invest in companies that are less stable than large cap companies. These funds can generate sharply negative returns in times of market instability when less-established companies can go out of business. On the other hand, they’re great investment tools for market players who can tolerate risk and are seeking aggressive growth. More conservative investors looking to increase returns may want to allocate a portion of capital to these funds, limiting risk through total exposure compared to the overall portfolio.
Mid cap funds invest in companies with market caps of $2 billion to $10 billion. Mid cap companies share some growth characteristics with small cap companies but generate less risk, at least in theory, because they’re slightly larger and better established. Mid cap funds don't always move in tandem with the broad market and may be less vulnerable to violent swings, compared to small caps. Mid cap funds can be great investment vehicles for investors seeking superior returns without the risk of small caps or the downside of index-linked returns typical in large caps.
Large cap funds comprise companies with market caps of $10 billion or more, i.e. the "big fish" of Wall Street. Due to their enormous size, fund managers are often forced to imitate blue chip benchmarks like the SP 500 or SP-100. This happens because mutual funds have restrictions on the level of ownership in one company, which is generally no more than 10% of their outstanding shares. This results in large cap funds being forced to own the same companies that comprise major market indexes.
Large cap funds can be great investment tools for market players who have long-term holding periods and are looking to buy and hold. They can generate steady returns and income for those who want to assume less risk They aren’t appropriate, though, for investors trying to “beat the market.”
Once you understand the fundamental differences among capitalization funds, it makes sense to examine real-world returns to get a clearer picture of what is right for your portfolio.
Morningstar’s small cap and mid cap funds have generally outperformed large cap funds in the last five years, but the specific instrument’s growth vs. value focus shows a sizable impact on bottom line results. This is typical behavior in a roaring bull market, like the period between 2013 and 2018, highlighting how potential investors need to go the extra mile and choose carefully between deceptively similar funds.
A three-vs.-five-year performance comparison adds useful data to the examination process. The three-year lookback, to the second quarter of 2015, allocates a relatively longer time frame to a turbulent period that dropped many equities into downtrends. The overall sampling follows the tiered results of the five-year lookback, but performance variations are more pronounced at three years, with small cap growth funds outperforming large cap value funds by a much wider margin.
Generally speaking, small cap and mid cap companies have the ability to produce greater returns than large caps through more agile and dynamic businesses that tend to be more growth oriented than larger conglomerates. It seems logical that a company with a $1 billion market cap can double its perceived value more easily than a $100 billion conglomerate. And, since share price factors into market cap measurement, a rapidly growing market cap correlates strongly with rising stock prices.
Consider this analogy. The small corner grocery store can probably switch products to accommodate customer demand more quickly than a mega-chain. Although smaller companies may not have the same price influence as larger companies, they can tailor their products to a specific niche to produce significant location and client-specific returns.
Large cap funds invest in larger companies while small cap funds take stakes in smaller, more sector-specific companies. So, when you buy a small cap fund, you have the opportunity to invest in a basket of successful corner stores instead of a mega-company. Also keep in mind that fund managers investing in smaller companies will often work hard to ensure their portfolio membership is financially sound, with skillful management teams.
A narrow focus on market capitalization offers unique benefits for mutual fund investors. Even so, other factors that include growth vs value can greatly impact returns over time. As a result, investors should understand the risks inherent in this popular market strategy.