Small cap funds seem to be all the rage at the moment, but why? To find out we need to have a look at what small caps actually are. Small cap mutual funds are essentially stock funds that comprise publicly listed companies with a market capitalization of anywhere between $300 and $2 billion. They’re aimed at investors who are looking for long term growth with medium risk to their capital.
They’re not for everyone however; they’re a lot more risky than standard mutual funds and can suffer some pretty severe drawdowns in a bear market. So in this article we’ll take a look at what small cap funds actually consist of, the benefits of investing in small cap funds and finally, what are the disadvantages of investing small cap funds?
What are small cap stocks and what are small cap mutual funds?
The term small cap refers to the capitalization of a corporation in the stock market which is any where between $300 and $2 billion. That figure is not set in stone and can vary from broker to broker. But since the classification is for convenience and broking purposes only it doesn’t really matter.
Small cap mutual funds are essentially mutual funds made up of small cap stocks. Small cap mutual funds don’t necessarily spread their investment across the full spectrum of the small cap market, since this would be too wide a spectrum. But they tend to specialize in one small sector such as technology or pharmaceuticals.
Do Mutual Funds Have A Free Hand In Investing In Small Cap Market?
By and large mutual funds have free market access subject to SEC guide lines. Like in any other sector, be it index stocks or the large cap stocks, mutual funds can have the freedom to choose stocks from here in any proportion. But it does not mean that they can invest in large volumes.
Mutual funds operate under strict guidelines from the SEC which doesn’t allow them to take controlling positions in any stock without making public their intention first. This effectively prohibits them from investing in smaller stocks, since even a small investment from a large mutual fund would likely take up 20% or more of the market capital of a small cap.
What are the benefits of investing in investing in small cap funds?
Because of their size and market immaturity, small caps can achieve staggering growth figures. Companies like Wal-Mart and Apple were once small caps and look at them now. If you invested $10,00o in Apple when they first floated you’d be a millionaire many times over by now.
The fact is large companies just can’t achieve the same level of growth, there is only so much pie to go around and if you already have two thirds of it there’s not a lot left. But small caps with only a tenth of a slice can easily double their share in a couple of years.
The other thing is small caps aren’t weighed down by large dividends. They keep the majority of their profits and reinvest them in the business for further growth. All this makes them attractive investments, but like everything else in the world of investment, there’s a downside.
What are the disadvantages of investing small cap funds?
Small cap funds are much less stable in comparison to other types of mutual funds, owing to their narrow focus and limited presence by volume in the market. Also small cap stocks are much more susceptible to market conditions than their big cap brothers. A small cap is likely to have a much less diversified product range and less capital reserves to fall back on when times get hard.
Small caps are certainly worth considering as part of your portfolio; just make sure they only take up a small part. If you put all your eggs in one basket you’re going to get burned sooner or later. So set aside a small percentage of your funds and try investing in small caps, the time is certainly right for strong growth right now.
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