If you’re just starting out in the world of investing, your parents have probably told you about the good ole days when small cap growth mutual funds made real money, we’re talking millions here.
It was around the time a little kid called Bill Gates sat down behind his Altair 8800 and started writing code and ended up creating a little company called Micro Soft.
Small tech companies like Bill’s were responsible for creating hundreds if not thousands of multimillionaires from people who invested in them at the beginning. Sadly those days are over, two bear markets in the last decade, did to small-cap growth funds what Conan O’Brien did to the tonight show.
But small-cap growth funds are back, and in a big way. Should you join for the ride? Possibly. But only if you keep small-cap growth funds as a small part of your portfolio, and only if you can stomach the occasional broadside to your capital.
A small-company fund invests in stocks of companies whose market capitalization is less than $2 billion. A small cap growth fund looks specifically for companies whose earnings are expected to grow rapidly.
The average small-cap growth fund has soared 18.9% this year, vs. 11.2% for the Standard & Poor’s 500-stock index. Why the out-performance?
Small-cap stocks often fare well in the early days of an economic recovery, in part because they’re more nimble and logically, small companies have more room to grow than big ones. A feisty small company with 5% of market share has better growth prospects than one that already controls 80% of the market.
Anther factor is that interest rates are typically low in the early stages of a recovery, and that, too, helps small-company stocks. Small companies can refinance debt at lower rates, which reduces expenses.
Why growth over, value investing, you know the type of bargain-hunting practiced by Warren Buffett? Well, growth is hard to find right now, since investors are willing to pay higher prices for the few rapidly growing companies out there and that isn’t going to change anytime soon.
So what could go wrong? well, just as small-company stocks tend to rise more in the early stages of a bull market, they tend to get clobbered harder in a bear market. The small-cap growth market tends to be dominated by technology, which can be astonishingly volatile.
The Russell 2000 small-company growth index fell 22% in 2000, 9% in 2001 and 30% in 2002. Losses like that will make your eyes water and your bank manger nervous.
To help keep you out of the red and in the black, here are some things to look for in a small-cap growth fund:
Size – Small is good. Few funds will buy more than 10% of a company’s outstanding stock. A $2 billion small-cap fund would need to pick hundreds of small-cap stocks to fill its portfolio. A $150 million fund, however, can be far choosier.
Flexibility – Some small-cap funds must sell their best holdings when the companies grow too large. But those are the companies most likely to see good midcap growth as well. Look for a fund that can hang on to its winners.
Expenses – It never makes sense to pay more than you have to for a fund.
Most of all, however, try to curb your enthusiasm. The kinds of gains that small-cap funds generate can be hard to resist. But for your own sake, don’t invest too much. You don’t want your portfolio to face extinction.
If you want to try investing in small caps yourself, I suggest joining OptionsHouse who are offering 100 free trades for a limited time to new customers. You may as well make the most of this offer while it’s available, OptionsHouse is a well trusted broker with an excellent platform along with world class support.