Mining Hidden Gems: Why Invest in Small-Cap Funds?

Small-cap funds can be a great way to gain exposure to companies with great growth potential while enhancing diversification in your portfolio.

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When it comes to the world of investing, you have your big names like Amazon, Alphabet (Google), and Meta (Facebook). These are three of what Wall Street refers to as the Magnificent Seven. These are some of the most established companies in the country. But what about the next big thing? These companies didn’t necessarily start out as the juggernauts they are today. So who’s to say a smaller company won’t come round to earn its place among the elite?

To find these companies, many investors turn to small-cap funds.

What Are Small-Cap Funds?

Small-cap funds invest in small-cap stocks. Small-cap companies usually have market capitalizations between $300 million and $2 billion. Market capitalization is calculated by multiplying the total number of company-issued shares by the market price of a single share.

Small-cap funds typically aim to track the performance of a broad stock market index like the Russell 2000. This includes the bottom 2,000 stocks of the Russell 3000 Index.

Small-cap funds invest in a variety of stocks, which offers instant diversification and takes away the hassle of individually trying to stock-pick. These assets can come in the form of professionally managed mutual funds, exchange-treaded funds (ETFs), and index funds.

So why consider small-cap stocks in the first place?

Growth Potential

Small-cap companies are often emerging entities with plenty of room to expand their operations. They are also often at the forefront of innovative technology and emerging business models, which could lead to rapid growth. The barrier to entry is also easier to penetrate as these are smaller companies than their large-cap counterparts.

Moreover, small-cap companies are often overlooked by institutional investors, which can lead to mispricing. This is where a savvy investor with their own analysis can come in and find hidden gems with the potential to become the next big thing.

But there’s another potential boost. Sometimes, small-cap companies do catch the attention of their larger counterparts. This can lead to acquisitions that could boost share prices.

Diversification

Small-cap stocks aren’t typically correlated to large-cap stocks. This means they may behave differently and exhibit different patterns. This can add to portfolio diversification and thereby reduce portfolio volatility and potentially boost risk-adjusted returns.

In fact, small-cap stocks have, historically, reflected greater return potential relative to large-cap stocks, with small caps outperforming large caps in 60 percent of 10-year rolling periods, according to research by Cambiar Investors.

In addition, investing in small-cap stocks can give your portfolio exposure to companies in various sectors and even niche markets, enhancing overall diversification.

Plus, small-cap stocks historically have rebounded quickly during economic recoveries.

Risks

As with any investment, there are some risks you should consider before deciding to invest in small-cap funds. First, small-cap companies may experience more volatility due to their small size. Their lack of resources could also impact how quickly or efficiently they acquire capital as opposed to their larger counterparts.

And because of potentially lower trading volumes, it can be, because of illiquidity, more difficult to buy or sell shares quickly without affecting the price. This can be especially challenging during market downturns.

And hidden gems may not always be what they seem. A competitor with a better product or service can come around and wipe out what many thought was going to be the next magnificent thing.

Top Small-Cap Funds

If you’re interested in jumping into the world of small-cap funds, here are some of the top funds you may want to consider:

• Boston Trust Walden Small Cap BOSOX
• Brown Capital Management Small Company BCSIX
• Champlain Small Company CIPSX
• DFA US Small Cap DFSTX
• Dimensional US Small Cap ETF DFAS

The Bottom Line

Small-cap funds can be a great way to gain exposure to companies with great growth potential while enhancing diversification in your portfolio. These are emerging companies that have plenty of room to grow through innovation. And because they lack the flair of their larger counterparts, Wall Street tends to ignore or overlook them. But this can lead to undervalued companies, and the right investor who identifies this can make a large profit by jumping into a cheap stock with the potential to skyrocket. Because a small-cap fund is professionally managed and invests in multiple stocks, you may not have to dig too deep to find the next hidden gem. You can start by investing in the top small-cap ETFs or mutual funds.

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