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Small-cap funds and large-cap funds are two of the most popular ways to slice and dice the investment universe. Small-cap funds are those that invest exclusively in "small caps," or companies with a relatively small market capitalization, which is the total value of the company's outstanding shares. In contrast, large-cap funds invest only in "large caps," or the biggest publicly traded companies.
That's the key distinction between the two types of funds, but investors really need to know how these funds could perform in their own portfolios and why they should invest in them.
Small-cap funds or large-cap funds will perform, generally, like their holdings. For example, small cap stocks tend to be more volatile than large cap stocks, and so too are small-cap funds. So it can make sense to understand some of the characteristics of each type of stock.
Small caps are stocks with a market capitalization of a few hundred million dollars to a few billion dollars.
Small caps as a whole have outperformed large caps over time.
Because of their relatively small size, they tend to have more growth potential.
Small caps have fewer financial resources and are generally less robust.
The stocks of smaller companies tend to be more volatile than their larger peers.
Small caps tend to have less overall business strength.
Typically, small companies pay dividends less often than larger companies, and they usually need to reinvest their profits for growth.
Large caps are stocks with a valuation of greater than $10 billion or so, though those above $200 billion are sometimes called mega-caps.
Large caps are considered safer than small caps and have performed well over time.
Large caps tend to have less growth potential because they operate in mature industries.
These stocks have deep financial resources and are generally financially robust.
Large caps tend to be less volatile than their smaller peers, because of their perceived safety.
Stocks of large companies usually have many business lines, giving them a lot of business strength and resilience.
Large caps often pay out a significant portion of their profits as dividends, since they need less of their earnings to support growth.
It's important to note the differences between small caps and large caps, but when they're combined into a fund, some of those huge differences collapse a bit. For example, while an individual small cap may be quite volatile, a fund of small caps is much less volatile. Similarly, while an individual small cap can vastly outperform, a collection of small caps tends to perform better than a large-cap fund, but the difference is less dramatic.
Below is data from Portfolio Visualizer comparing the performance of large-cap stocks to small-cap stocks from 1972 through May 2022. This data provides an idea of how a fund composed of these market segments would have performed.
| Performance, 1972-2022 | Large caps | Small caps |
|---|---|---|
| Total annual return | 10.5 percent | 11.5 percent |
| Standard deviation | 15.3 percent | 19.6 percent |
| Best year | 37.5 percent | 55.1 percent |
| Worst year | -37.0 percent | -36.1 percent |
| In 50 years, |
Source: Portfolio Visualizer
Small caps performed better than large caps by a full percentage point, which doesn't seem like much at first. But over time that difference turns into a nearly $1 million difference in wealth. If you invested $10,000 in each category in 1972, it grew to $1.52 million in large caps but $2.47 million in small caps.
Those higher returns require a stronger stomach, though. The standard deviation for small caps shows these smaller companies have much greater volatility than their larger peers. But that volatility can also lead to individual years that vastly outpace the larger stocks. The best year for small caps saw them rise more than 55 percent, compared to 37.5 percent for large caps.
In recent years, large-cap stocks have meaningfully outperformed small-cap stocks, as tech giants such as Nvidia ( NVDA ), Microsoft ( MSFT ) and Apple have accounted for a large portion of market returns. Over the past decade, the Russell 1000 Index, which is made up of large-cap companies, has seen annualized returns of about 12.4 percent, versus just 7.4 percent for the Russell 2000 Index, which is comprised of small-cap companies.
Given the performance of small caps and large caps, some investors might be tempted to put all their money in one or the other. But it makes more sense to balance your portfolio, with portions allocated to small-cap funds and large-cap funds - and mid-cap funds, too.
Here are some of the key issues to consider in weighting your portfolio to each:
Overall stability: Large caps provide a good solid base for any portfolio, given the holdings' financial and business strength, and the returns have been good over time.
Size of the market. Large caps are a much larger portion of the stock market, so it can be tough to build a portfolio without having some large-cap funds.
Diversification. Having both kinds of stock funds reduces risk in a portfolio, and many advisors favor having a bigger exposure to large-cap funds, given their stability.
Point in the economic cycle. Small-cap funds tend to do well coming out of a recession, but that's largely a result of falling more going into a recession. So, they can be a particularly good buy as the market is bottoming amid a recession. As the economy booms or even slows, investors tend to favor large caps for their stability and dividends.
Need for income. If you're looking for dividend income, then large-cap funds are likely to be a better choice, given the financial strength of the underlying companies.
Aggressive vs. conservative. If you're looking to invest more aggressively within stocks, it may make sense to increase your allocation to small-cap funds. If you're looking to be more conservative, then a higher allocation to large caps is better.
Your age. Along the same lines, your age might indicate how conservative or aggressive you want to be with your investments. If you have a long time until you need the money, then you can afford to take more risk with a higher allocation to small-cap funds.
Value vs. growth funds. Small-cap funds and large-caps funds can be further divided into those that are oriented to value investments or growth investments. Each type does better in different markets, and all funds are not the same.
Expense ratio. The expense ratio is the cost to own a fund, as a percentage of your investment in it. Many small-cap funds charge higher fees because the space requires more analysis to find and invest in the stocks. Fees on large-cap funds can be very cheap, often under 0.10 percent annually, or $10 for every $10,000 invested.
While we've been discussing small-cap funds and large-cap funds as if they're uniform entities, there's huge variation in each of the categories. So, investors should look carefully at a fund's investments, its investment mandate, its track record and other specifics of each fund.
And sometimes winners keep on winning: the top funds can do well year after year, so it can make sense to check out lists of the best small-cap funds and best large-cap funds.
If you're investing in any kind of fund - small caps, mid caps or large caps - it's important to understand how the fund is managed. Broadly speaking, funds are managed in two ways:
Actively managed funds: In this kind of fund, a team of analysts and a portfolio manager analyzes stocks and tries to find the best opportunities to beat the market. This fund trades in and out of the market regularly and generally costs more than a passively managed fund because it has to pay a team of analysts.
Passively managed funds: This fund mechanically replicates a specific index of stocks or bonds rather than having a team of pros analyzing them, and is also called an index fund. When the composition of the index changes, only then does the fund change.
While it may seem as if actively managed funds are going to be clear winners, it's actually very difficult for actively managed funds to consistently beat their passively managed counterparts. And it's not only in terms of performance that passive funds usually win: They usually have a lower expense ratio, making them lower cost for investors to own.
Most exchange-traded funds (ETFs) are passively managed, making them low-cost picks. Meanwhile, many mutual funds are actively managed, though not all. But in some cases, mutual funds are cheaper than their ETF cousins. Here's the breakdown of ETFs vs. mutual funds and what you need to know.
Small-cap funds can add some extra spice to your investment portfolio, helping to boost your overall investment performance over time. But you'll want to weigh that against the stability and still-attractive returns of large-cap funds. Finally, it's worth noting that investors should not assume all small-cap funds and large-cap funds are the same, so it's vital to look at the long-term track record of the funds as well as how much it costs to own the fund.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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