Before we can understand the difference between various types of funds, we must first understand market capitalization.

Put simply, market capitalization—or market cap—is one of the most commonly used measures to gauge the size of a company. More specifically, it’s the value of all of a company’s outstanding shares (shares currently held by investors).

Market cap is calculated with a simple formula: share price x number of shares outstanding.

So let’s say Company XYZ had 7 million shares outstanding, and shares are trading at $50 apiece. The company’s market cap in this case would be $350 million. This would be considered a small-cap company.

Market cap is generally divided into six categories defined by these parameters:

  •     Mega-cap: More than $200 billion
  •     Large-cap: $10—200 billion
  •     Mid-cap: $2—10 billion
  •     Small-cap: $300 million—2 billion
  •     Micro-cap: $50—300 million
  •     Nano-cap: Less than $50 million

However, most public companies fall into the large-, mid-, and small-cap categories.

But there’s more to market cap sizes than simply a company’s balance sheet. These market cap categories often boast other important characteristics. For instance…

Typically, large caps are established, sturdy companies that have been around a while. They operate in safe, necessary industries and tend to deliver healthy—if unexciting—returns to shareholders over the long term. However, they don’t have as much room to grow, so their ultimate return potential is somewhat limited.

Meanwhile, mid caps tend to be somewhat established, but with room to expand. You can often find these companies in strong but still growing industries. They’re riskier than large caps, but less risky than small caps. They tend to be attractive for their blend of growth potential and moderate risk—a balance between large and small caps.

Finally, small caps are often infant companies with much fewer resources at their disposal. You’ll see a lot of these names in risky and/or niche industries. Small-cap companies are inherently volatile and illiquid for several reasons: less money to spend, a young age, untested industries, etc. However, with the greatest risk often comes the greatest reward… These names—when successful—are known to reward their shareholders with the highest returns in the shortest amount of time.

The trick is finding the true winners in a sea of deeply risky names—and that is no simple task.

The Difference Between Funds and Stocks

If you’re a research-focused investor with a lot of time to spend analyzing specific stocks, that’s great! But not everyone has the capacity to get into the trenches like that.

As such, for the average investor, funds present a more passive alternative.

Funds are investment vehicles that own a basket of other assets. In other words, when you buy a fund, you’re immediately diversifying your portfolio among a wide variety of names. You’re also limiting your risk exposure to a single company; since a fund essentially represents a portfolio in itself, the risks of a single name are blunted by the other holdings.

But, as with anything in investing, not all funds are created equal… Their value is ultimately determined by their underlying assets. And choosing the right fund for you will depend on your specific investment profile, goals, and time horizon.

Mid-Cap vs. Small-Cap Mutual Funds

A mutual fund (like all funds) is directly invested in a wide variety of assets—stocks, bonds, equities,  money market assets, etc. The average mutual fund contains hundreds of various assets… and thus gives investors direct exposure to everything it holds. Mutual funds are calculated based on their net asset value (NAV), pricing once at the end of each day (unlike stocks, whose prices fluctuate throughout the trading day).

But mutual funds and stocks do have something in common: they come in all shapes and sizes.

For instance, small-cap funds are mutual funds that—you guessed it—invest primarily in small-cap stocks. These funds tend to reap the same rewards as small-cap stocks… because that’s what they hold: while these names tend to be riskier, they also have historically delivered higher returns for investors than have large caps. Why? Because (assuming they’re solid stocks) small caps focus on aggressive growth. Meanwhile, the growth potential of large caps tends to be limited.

The other nice thing about small-cap funds is that, since small caps are newer and less established, they’re not as attractive to big-name investors-which means they’re often less expensive and easier to buy into for the average investor.

Still, like small-cap stocks… small-cap funds pose more risk than their larger counterparts. More risk means fewer investors (since most investors have a lower risk tolerance). Fewer investors means less liquidity (the ability to buy and sell quickly and easily, since there are fewer buyers). Less liquidity means more volatility (rapid price movement over a short span of time).

So, in other words, in addition to the increased risk, small caps also make you more susceptible to daily market movements… and it’s harder to sell your shares.

Meanwhile, mid-cap funds are also exactly what they sound like—funds that mainly invest in mid-cap companies.

While mid-cap stocks offer slightly less exposure to growth than small caps, they offer substantially lower risk. Between 1979 and 1998, for instance, allocating 40% of your portfolio to small-cap funds would have delivered about the same returns—with higher risk—than allocating the same amount to mid-cap funds.

What About ETFs?

Exchange-traded funds (ETFs) are another type of fund. Like mutual funds, they represent a basket of assets across a variety of markets and sectors. However, unlike mutual funds, ETFs trade like stocks—they trade on exchanges and price throughout the trading day. Also, mutual funds tend to be more actively managed, which means they often come with higher fees… Meanwhile, ETFs are generally more passively managed, and are thus less expensive to invest in.

Since ETFS, like mutual funds, are focused across a variety of industries and investment instruments, they also offer the option to buy into a basket of small- and mid-cap names.

The investment vehicle you ultimately decide upon will depend on your specific investing wants and needs. It’s important to know where you’re invested… and make sure each investment continues to meet your specific profile and goals.