As a general rule, small-cap and mid-cap funds have outperformed large-cap funds, and the trend is not likely to change anytime soon. As a result, prospective investors need to have a strong understanding of market capitalization ("market cap") in order to effectively begin their search for mutual funds. Here we explain the differences between the various types of funds and look at the kinds of returns you can reasonably expect from them based on historical data.

Different Funds, Different Market Caps
When a mutual fund is described in terms of market cap (i.e., small cap, mid cap or large cap), it indicates the size of the companies in which the fund invests, not the size of the mutual fund itself. Market cap is calculated as the number of shares outstanding multiplied by the current market price of one share. Thus, a company with one million shares outstanding selling at $100 per share would have a market cap of $100 million.

Small-Cap Funds
Small-cap funds typically include companies with market capitalization of less than $1 billion (bear in mind that these numbers are only approximations that change over time, and the exact definition of these categories can also vary between brokerage houses). Generally speaking, smaller companies are those in the early stages of business. They are presumed to have significant growth potential, but are not as financially strong or as established as larger companies.

Because small-cap funds invest in companies that are less stable than large-cap companies, the funds can be quite volatile. This has its advantages and disadvantages. In times of market instability, small-cap funds can suffer greatly as less-established companies go out of business. On the other hand, small-cap funds can also be great investments for those who can tolerate more risk and are looking for more aggressive growth. Investors hoping for aggressive returns will certainly want to park some money behind these funds. Finally, many mutual funds cannot take substantial positions in small-cap stocks without filing with the Securities and Exchange Commission (SEC), and this usually means greater transparency when it comes to the fund's holdings.

Mid-Cap Funds
The most popular choice among the general investing public, mid-cap funds are those that invest in companies with market caps of $1 billion to $8 billion. Mid-cap companies share some of the growth characteristics of small-cap companies, but they entail less risk (at least in theory) because they are slightly larger. You might say that mid-cap funds are to the mutual fund market what mid-size cars are to the automobile market. The mid cap is a compact vehicle for the market, falling somewhere between those sporty little small caps and the massive SUV type large caps.

Mid-cap funds don't always move with the broader market, and they are also usually not as prone to violent swings as small caps. Mid-cap funds can be great investment vehicles for investors seeking a fund with great return possibilities - without the risk of small caps - and index-related returns like those of large caps.

Large-Cap Funds
Large-cap funds comprise companies with market caps of $8 billion or more - the "big fish" of Wall Street. However, because of their enormous size, large-cap funds are often forced to imitate a larger index, such as the S&P 500. This is because mutual funds have restrictions on the level of ownership they can have in any one company, which is generally no more than 10% of their outstanding shares. This results in large-cap funds being forced to buy large companies - the same ones that make up the major market indexes.

Large-cap funds can be great for investors who have longer-term investment timelines and would like to "buy and hold". There are many large-cap income funds that are great income vehicles for those who want to take on less risk. But for those seeking greater diversification in smaller, more aggressive companies, large-cap funds probably aren't the answer.

Looking at Returns
Once you understand the fundamental differences among small-, mid- and large-cap funds, it's important to look at real world returns to get a clearer picture of what is right for you.

Figure 1

If you look at the table showing Morningstar Funds in Figure 1, you will see that small- and mid-cap funds outperformed large-cap funds over the five-year period reviewed. And, although it's not shown in this table, the same is also true for a 10-year period. For the five-year period between 2001 and 2006, the Dow Jones Industrial Average returned a meager 1.38%, while the Nasdaq Composite came in only slightly higher at 1.63%. Figure 1 also shows that, with the exception of the Morningstar Large Value, the rest of the large-cap returns hover around the returns of the broader indexes. The conclusion is that in years of moderate index returns, small and mid-cap funds can often produce more significant returns than their large-cap counterparts.

Breaking It Down
Why have small and mid caps been producing greater returns than large caps in recent years? Generally speaking, small and mid-cap companies have the ability to produce greater returns through more agile and dynamic businesses that tend to be more growth oriented than larger conglomerates. Simply put, a company with a $1 billion market cap can much more easily double its entire market cap than a large conglomerate of $50 billion. And because share price is an important factor in measuring market cap, a rapidly growing market cap most often translates to the price of the stock climbing higher as well.

Of course, there will always be examples that buck the trend, but overall, the numbers show that small- and mid-cap funds are goods bets for higher returns.

Consider this analogy: the small grocery store on the corner of your street is probably able to switch its products much more quickly than a mega-chain like Walmart, right? Although smaller companies may not have the same price influence as larger companies, they can tailor their products to a more specific audience to produce significant location and client-specific returns. Large-cap funds invest in larger companies, while small-cap funds take stakes in smaller, more sector-specific securities. So, when you invest in small-cap funds, it\'s like you have the opportunity to invest in 100 successful corner stores instead of a mega-company like Walmart.
Also keep in mind that when fund managers invest in smaller companies, they work very hard to ensure that the small and mid-cap companies are financially sound and have healthy management teams.

The Bottom Line
When you consider what type of mutual fund is right for your portfolio, it's crucial that you remember that there are many other factors to consider, including whether the fund specializes in growth, value or another investing style. What's more, you have to be able to distinguish between load or no-load funds, and determine whether you prefer open or closed-end funds.

As always, you need to do your homework and research the funds in which you are investing - mutual fund companies have been known to roll their bad funds into better performing funds. Understanding the pros and cons of the various market cap funds is a good first step to determining which funds best suit your portfolio and your investment style, but a savvy investor knows that his or her work is never done.

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