Small Cap Funds | Growth vs Value Funds

These are funds that invest in companies with a market cap of less than $2 billion. Money managers of small cap funds invest in small stocks that have potential and room for substantial growth. They can be in the form of mutual funds, index funds, ETF's or hedge funds.

Small cap refers to a company's market cap, which is the measurement of it's size. It is calculated by taking the share price and multiplying it by the number of outstanding shares in the company.

If utilized strategically, small cap funds can be a good way to see extraordinary returns in a well-diversified investment portfolio. Given enough time and attention, this is a great way to see good returns over the long-term.  Here is some investment advice on these small funds.

There are close to 40,000 small cap stocks under a marke cap of $2 billion on the three major stock exchanges (NYSE, NASDAQ, AMEX). These are the pool of stocks managers work with to create these funds.

There are two categories of small cap funds, growth and value. Growth funds tend to seek out very aggressive returns by investing in companies that are on the brink of explosive growth. Small cap value funds seek out small companies that are undervalued.

These are two different strategies and investment models within the same sphere of market cap stocks. Each one will require a different approach and mindset from you as the investor.

In addition, you can find some funds that are a hybrid of both growth and value. An example of this would be the Fidelity Small Cap Discovery Fund.

Small Cap Growth

These funds invest in small companies with great growth potential with an eye for high returns. These would be companies that have unique and disruptive technology. Money managers who are managing small cap growth funds seek to find the next Google or Microsoft.

These money managers also look for small companies that have the potential to be bought through acquisition from a large cap company. This will usually send the stock price higher.

These funds tend to be very volatile due to the high risks that comes with investing in these companies. That is why an investor who has these funds in his portfolio would do well to keep a close eye on it's performance.

That doesn't mean you should pull out of these funds if they should perform poorly in a given year. In fact, most of these funds will probably have a loss in any given year. So the question isn't, did this fund lose in a particular year. The question you need to ask is how has this performed over time.

Small Cap Value

Small cap value funds seek out companies less than $2 billion that look like they are being undervalued by the market. The best known value investor would be a guys like Warren Buffett. Although, Buffett is most famous for his buying up of undervalued large cap companies.

Fund managers figure out what the real value of companies are and look for those that are undervalued by the stock market. They buy them up at these discounted prices hoping that the rest of the market will eventually catch on to their real value and push the price up.

Because managers for these value funds look more toward fundamentals to guide their investment decisions, they tend to be less volatile than growth funds. To be sure, even these funds tend to still be more volatile and risk than large cap or mid cap funds.

Buying into small cap funds has a market timing component to it. These cap size stocks have a cyclical characteristic depending on the state of the economy.

Small caps tend to take a dive during economic recessions and downturns. When the economy is entering into a recession, investors pull their money out of higher risk instruments like small cap stocks and put them in safer havens like large cap stocks, bonds, Treasury bills and gold.

The best time to buy into small caps is when the market is on the brink of recovering and the downward trend of stock prices have run it's course. Then you can buy when the price is as low as it's going to get.

These funds tend to do very well in good economic times. When investors are confident that the economy is on course for a sustained recovery, they will take their money out of safer financial instruments like bonds, large caps and gold and put it into higher risk and return potentials like small cap stocks.

Long Term Investing

Investing in small cap funds is probably best suited for young investors. Because of the volatility and cyclical nature of these funds, you need time to let the funds recover after periods of loss.

In addition, in a down market, you need time for the entire economy to pick back up before you begin to see returns.

If you are close to retiring, many financial advisors recommend that most of your investments should be in large caps or fixed income assets. Any capital you put toward small cap funds should be reserved for money you don't need anytime soon, or you are willing to lose.

There are a variety of ways to get into small cap funds. You can do it through an actively managed mutual fund, index fund, ETF or hedge fund.  All of these investment vehicles have it's own unique set of characteristics, strengths and weaknesses.

Actively Managed Mutual Funds

Actively managed mutual funds is the traditional method of investing in managed funds. These funds are actively managed funds, which mean there is a money manager that is hand picking every stock, deciding how much to invest in each and deciding when to sell.

As you can imagine, a lot of work goes into these types of funds. Accordingly, these funds have high expense ratio's and will tend to be more expensive. In addition, you have the added risk of human error.

Index Fund

These funds track an index like the S&P 600 Small Cap 600 Index make investments. Index funds are typically passively managed, which also means that the expense ratio or cost of managing these funds are much lower. Accordingly, the management fees for index funds are quite low.

ETF - Exchange Traded Funds

ETF's are funds that are traded on the stock exchanges just like a regular stock. The price of EFT's tend to be the net asset value of the stocks that the fund is comprised of. And fees are just your normal commission you'd pay to your stock broker or online brokerage.

Hedge Funds

Most hedge funds have their own special sauce that they rarely share with anyone, including the investors. Many do trades in small cap stocks for quick gains and high returns. You have to have a certain net worth to be able to invest in a hedge fund so it's usually out of reach for more investors.