Small cap stocks—those with a market capitalization of between $300 million and $2 billion—tend to be riskier investments than their medium- and large-cap counterparts. Nevertheless, they offer huge upside for those willing to take the plunge. However, many investors don’t have the risk tolerance to invest in individual small cap stocks. Instead, they choose to mitigate risk by broadening their exposure through small cap mutual funds. 

Small cap mutual funds maintain a clear-cut focus on small cap companies; however, they offer benefits that alleviate much of the risk of investing in them individually. Here’s a look at what they are, how they work, and the advantages and disadvantages to holding small cap mutual funds in your portfolio. 

What is a Mutual Fund?

A mutual fund is a collection of stocks, selected and managed by a professional. Investors buy into the fund, as opposed to holding positions for every individual company. Mutual fund investors pay a small fee to “set it and forget it,” while the fund manager takes charge of rebalancing and transacting on behalf of the fund. In the case of small cap mutual funds, the focus of the fund is specific to smaller companies with higher upside and growth potential. 

Through mutual funds, investors alleviate the duty of managing their own investments. Moreover, they mitigate risk by investing in a diversified fund—even if every stock within the fund is technically a small cap company. While fees can eat into profits, mutual funds are the perfect investment vehicle for long-term, passive investors. 

Top-Performing Small Cap Mutual Funds

Not sure where to get started with small cap mutual funds. There are plenty of well-regarded institutional funds to explore. Here’s a look at some of the best-performing examples over the last decade:

• DFA US Small Cap I (DFSTX)
• iShares Core S&P Small-Cap ETF (IJR)
• Schwab US Small-Cap ETF (SCHA)
• T. Rowe Price QM US Small-Cap Gr Eq (PRDSX)
• Vanguard Small Cap Index Adm (VSMAX)
• Vanguard Tax-Managed Small Cap Adm (VTMSX)
• Wasatch Small Cap Growth Investor (WAAEX)

These are a small sampling of small cap mutual funds and there are dozens more to choose from. Better still, there are options specifically engineered to incorporate different areas of exposure. For example, small cap emerging market funds or small cap funds focused on disruptive technology companies. Investors can tailor their investment preference and, alongside that focus, manage their risk. 

Types of Small Cap Mutual Funds

As is the case with any type of investment vehicle, the focus of a small cap mutual fund is what makes it unique. It’s an opportunity for investors to exercise their own level of risk tolerance. Some of the most common types of small cap funds (from least risky to riskiest) include:

• Broad market small cap mutual funds
• Emerging market small cap funds
• Sector-specific small cap funds
• Leveraged small cap funds

The composition of a fund depends on the fund’s directive and the decisions of its management. Generally, however, funds will bill themselves in one of the above categories (or similar) to attract investors that fit that risk profile and who understand the nature of those specific investment parameters. 

Small Cap Funds are Growth by Default

The draw of small cap companies is their growth potential. This enticing prospect translates to small cap funds, which are growth funds by default. Small caps lack the earning potential to offer sustainable dividends, which makes price appreciation their primary draw for investors. Thus, the success of small cap mutual funds relies on the fund manager’s ability to cultivate a portfolio of small companies with high growth potential.

For investors, a fund filled with well-chosen growth stocks represents exceptional performance potential. Instead of betting on one company to return 10x over 10 years, for example, a mutual fund can see exponential returns as its many holdings return 5x, 6x, 10x or more over that time period. Investing in small cap funds effectively broadens an investor’s potential for ROI to include as many stocks as there are in the fund. 

The Risks of Owning Small Cap Mutual Funds

Small cap mutual funds aren’t without risk. Sometimes, even the diversified nature of a fund isn’t enough to mitigate the impact of market volatility. This is especially true for focused funds—small cap tech stocks or emerging market small caps, for example. 

Mutual funds aren’t always the best vehicle for small caps, either. Many investors choose to invest directly in a broad index such as the Russell 2000 (RTY) as a way to capitalize on diversification, while still remaining small-cap focused. In doing so, they also absolve themselves of mutual fund fees.

Mutual Funds Balance the Risk of Small Caps

Mutual funds continue to be one of the most popular investment vehicles for everyday investors—especially passive investors. Those with an appetite for risk will find themselves gravitating toward small cap mutual funds, enticed by the potential of high upside. And while small cap companies traditionally face headwinds and volatility, when packaged in a mutual fund, diversification often proves stabilizing. 

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For instance, keep an eye out for mutual fund fees—they tend to range higher for small cap funds, to offset risk. And, consider the fund’s performance vs. a broader small cap index before investing. Many small cap mutual funds have great upside and proven potential. However, it’s up to investors to identify them based on their own risk tolerance and area of focus.