Investors understand the importance of having a proper balance of large-, mid-, and small-cap companies in their stock portfolios. Unfortunately, there are no strict rules followed by index funds when categorizing by company size. When you “check under the hood” of your portfolio, you may discover you’re taking more (or less) risk than you intended!
What Is Market Cap?
Market capitalization, or market cap, is a term used to represent the size of a company. Generally speaking, three main categories of market caps exist within U.S. stocks: large, medium, and small.
Large-cap stocks include many familiar names such as Apple, Microsoft, and Disney. Your portfolio will typically contain a higher percentage of large-cap stocks because their size and profitability are much less vulnerable to market downturns or other threats as compared to smaller companies.
Over the long run, smaller-cap stocks may give your portfolio’s return potential a boost. However, they are associated with more risk such as:
- Less liquidity. Fewer people trade smaller-cap stocks, so finding the right price to buy or sell shares can be more difficult.
- Reduced financial resources. Besides less access to financing, smaller-cap stocks may find it more challenging to undergo large capital expenditures or to remain sustainable during economic lows or periods of weak cash flow.
- A relatively unproven business model. They often have less operational history compared to larger companies.
How Do I Tell the Difference?
Benchmarks have been created to track the performance of large caps, mid caps, and small caps. You might think there would be a single, agreed-upon scale for defining stocks by company size, but that’s not the case. Investors typically rely upon definitions implemented by a variety of major indexes such as the Standard and Poor’s 500 or the Russell 1000 to track large-cap stocks.
If you google market cap ranges, you’ll receive a mixed bag of definitions. One of the top results cites the following dollar-defined ranges:
- Small-caps: Under $2 billion
- Mid-caps: From $2 billion to $10 billion
- Large-caps: $10 billion and over
While these are widely accepted ranges, not all major index benchmarks use these specific ranges. They may use an entirely different approach to defining what is included for each capitalization category.
For example, FTSE Russell, a major provider of stock market benchmarks in the U.S., takes a ranked approach. The large-cap Russell 1000 index simply includes the 1000 largest publicly traded U.S. companies. How does this compare to the widely accepted dollar-defined large-cap range? As of May 2018, the Russell 1000 index included companies with market caps ranging from $2.5 billion all the way up to the largest market cap on that date, Apple Inc. at $926 billion. This is in contrast to the dollar range of “$10 billion and over”.
To continue our comparison, the Russell mid-cap index benchmark ranged from $2.5 billion to $34.7 billion compared to the dollar-defined range of $2 billion to $10 billion. And the Russell 2000 small-cap index benchmark ranged from $159 million to $5 billion compared to the dollar-defined range of everything under $2 billion.
So, Why Does It Matter?
How market cap is defined can make a big difference in what you might want to include in your portfolio.
Take small caps, for example. If you decide to target 10 percent of your portfolio in small-cap stocks, taking an index-based approach, you might select a mutual fund with “small cap” in its name for that 10 percent of your portfolio. Generally speaking, a “small-cap” fund should hold small-cap stocks, right? Not necessarily! You can’t be sure until you’ve done your research.
When you look under the hood, you may find that 50 percent of your “small-cap” fund is actually composed of mid-cap companies. The two categories are blended in its holdings. As a result, instead of having 10 percent of your portfolio in small-cap stocks, you could end up with only 5 percent! This may shift the risk/return profile of your portfolio to something different than what you had intended.
Conclusion
Standardization among the index mutual funds and the benchmarks would make our investment decisions easier! But since that is not the case, you should review the underlying stocks in each index mutual fund before you invest. Then when comparing the performance of your index fund to its market cap benchmark, be aware the range of company size may not be the same. Where investing is concerned, “diving under the hood,” will help create a portfolio that better meets your expectations!
Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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