As we start our journey into mutual funds, I think it is best to break down and dissect the various equity mutual fund categories.
As we can see in the equity mutual fund style box below, there are forty-eight categories of various mutual funds with categories from three modes of criteria: Investment Style, Market Capitalization and Location. Another mutual fund factor that is not included in this style box are mutual funds categorized by Industry Sector. These factors will be discussed in future articles.
In this piece, I will focus squarely on Market Capitalization.
Large Cap Mutual Funds (otherwise known as big-cap mutual funds) are mutual funds comprised of companies with a market capitalization over $8 billion dollars. It is typical for well-known firms such as Microsoft, McDonalds, Apple and Caterpillar to be a part of this mutual fund category.
There are large cap mutual funds that are a direct imitation of major stock indexes such as the S&P 500. These type of mutual funds are index funds. These type of funds have the added benefit of providing low operating expenses. However, there are many large-cap mutual funds that look for the ideal mix of large-cap stocks that will outperform the S&P 500.
Investment Implications: Investors that are seeking a long-term investment timeline with a minimal amount of risk should ideally invest in large-cap funds. Due to the fact that large-cap firms are more stable and secure, they have a diminished amount of market volatility and risk. As a result, large-cap firms typically generate a smaller net return as opposed to mid-cap, small-cap and micro-cap mutual funds.
MID-CAP MUTUAL FUNDS
Mid-Cap Mutual Funds typically invest in companies with a market capitalization of $1 billion to $8 billion in general. This is the most popular category among investors due to the fact that mid-cap firms share some of the growth prospects of small-cap companies, yet are less risky due to their size.
While Mid-Cap Funds have greater volatility than their large-cap counterparts, they are not as susceptible to significant market swings as small-cap mutual funds. However, it is to be assumed that a mid-cap firm that is closer to the low-end of the market cap ($1 billion) will have the potential for increased volatility and net return that would be reminiscent of a small-cap fund. Many mid-cap firms can be characterized as former small-cap companies that have evolved in market capitalization. Undoubtedly, they could have the potential to make it to the large-cap category.
As shown in the image below, mid-cap firms have managed to avoid the market downswings that small-cap companies have been caught up in over the past three decades.
Investment Implications: Mid-Cap Funds are great for investors who are willing to accept a greater amount of volatility and risk in order to achieve a greater net return for their fund. They are willing to accept a greater amount of risk and volatility than a large-cap fund investor, but not as much as a small-cap fund investor. Thus, these type of investors are essentially in the middle of the pack.
SMALL CAP MUTUAL FUNDS
Small Cap Mutual Funds are funds comprised of companies that have less than $1 billion in market capitalization. They are usually traded in the Russell 2000 index. Small-cap companies are in the early stages of their development as overall businesses. They have a tremendous potential for growth. However, they are not as established as firms in the mid-cap or large-cap category. Thus, they are not stable. Small-Cap companies are prone to volatile swings by the market. As shown by the aforementioned graph, small-cap firms are highly susceptible to a significant reduction if the market is on the downside. Thus, small cap firms are much riskier investments than mid-cap stocks or large-cap stocks. However, small caps pose higher net returns than mid-caps or large-caps.
Investment Implications: Small-Cap funds are great for investors that are looking for aggressive stock growth and a significant net return. These types of investors should have a vast amount of knowledge and savvy when it comes to such investments. Small-Cap investors are willing to throw caution to the wind as far as risk and market volatility are concerned.
MICROCAP MUTUAL FUNDS
Micro-Cap mutual funds are funds with companies that consisted of firms with market capitalizations that are between $50 million to $300 million. This group usually consists of penny stocks. A simple way of describing micro-caps that they are the extreme version of small-cap companies. Micro-Cap firms are full of unestablished and potentially unknown companies that are extremely volatile to market conditions. They are extremely risky investments. Yet, the right micro-cap fund can potentially put an investor in a position to pose greater returns than small-cap, mid-cap or large cap funds.
Investment Implications: Basically, take the investment implications summary of small-cap companies and multiply it by 10. Given that micro-cap companies are at the extreme end of the small-cap category, the investment implications are intensified as well. Micro-cap investors are willing to take the most significant amount of risk and market volatility. However, they enjoy very high returns.
To summarize, I have constructed a 5X4 style box that illustrates the implications of the market capitalization funds based on risk, market volatility and growth.