Small-cap stock funds can be smart long-term holdings, but knowing the best time to buy them can help boost long-term returns. There are some smart ways that active investors can adjust exposure to small-cap stock funds to potentially enhance long-term performance.
Small-cap stock funds were affected by the pandemic downturn but are poised for a quicker turnaround and recovery, because they tend to be made up of more small domestic companies than their large-cap counterparts.
Maximize Returns With Small-Cap Stock Funds
Some investors choose an appropriate allocation of small-cap stock mutual funds and stick to the allocation for the long term. They rebalance the portfolio on a periodic basis, such as once per calendar quarter or once per year.
Pure market timing is not a good investment strategy but there are some strategic and tactical moves that investors can make to maximize returns.
Keeping an eye on market and economic trends can provide clues about buying opportunities. For example, at the end of 2018, stocks were down nearly 20% from previous highs. Early in 2019, the Federal Reserve began actively lowering interest rates, and it subsequently increased this activity to support the economy in 2020 during the COVID-19 pandemic.
On January 26, 2022, the Federal Reserve increased its target rate range for federal funds to .25%–0.50%.
Another way to look at the best time to buy small-cap stock funds is when it seems that the market has been down for a long period of time. That can be difficult to guess correctly, but a low point is typically when extreme pessimism can be seen and felt in both the national and international media, especially financial media.
How Small-Cap Stocks Can Beat Large-Cap Stocks
Small companies can begin to rebound in growing economies more quickly than larger companies. Their collective fate isn't tied directly to interest rates and other economic factors to help them grow. Like a small boat in the water, small companies can move more quickly and navigate more precisely than the large companies that move like giant ocean liners.
Decisions about new products and services and how to bring them to market can also be made and implemented more quickly with small companies, because they have fewer committees, fewer layers of management, and fewer potential obstructions of the kind that exist in the typical bureaucratic organization of large companies.
When the economy begins to emerge from recession and starts growing again, small-cap stocks can respond to the positive environment and potentially grow more quickly than large-cap stocks.
Small companies—and most growth-oriented stocks across all capitalization levels—typically raise most of their capital from investors by selling shares of stock. Larger companies borrow money by issuing bonds. Higher interest rates have less negative impact on the ability of small companies to grow, because they don't rely heavily on bonds to expand operations and fund projects.
Investing In Small-Cap Stock Funds
As with other types of mutual funds, investors have several choices about how they want to invest in small-cap stock funds. The primary choices are between actively managed funds and passively managed funds:
Actively Managed Small-Cap Stock Funds
Under active management, the manager of the fund has discretion as to which stocks to buy or sell and the timing of placing the trades. While a successful manager can help to produce above-average returns, they are human, which means they can make mistakes.
Passively Managed Small-Cap Stock Funds
Funds that are passively managed do not attempt to produce above-average returns. Instead, they passively track the performance of an underlying index. One common index that small-cap stock funds track is the Russell 2000 index. Since passively managed funds cost less to manage, their expense ratios are often lower than those of actively managed funds.
The Bottom Line
Small-cap stock funds are generally considered to be more aggressive investments than large-cap stock funds. That is because small companies can be more affected by changes in the economic environment. During a recession, small-cap stocks can see larger declines in price, whereas during economic recoveries, they can rise in price more quickly than large-caps.
Investors who want to take advantage of price fluctuations can choose to buy more shares of small-cap stock funds during market corrections. However, it's important to keep in mind that market timing is not a smart strategy for most investors. One simple strategy to manage a portfolio is to dollar-cost average with consistent purchases and to rebalance the portfolio at least once per year.
Frequently Asked Questions (FAQs)
What is a small-cap company?
The "cap" in "small-cap" is short for "market capitalization." That's the total value of the company, as measured by adding together all of the shares at their current prices. Small-cap companies are those with market capitalizations of between $300 million and $2 billion. The smaller companies just below small-caps are called "micro-caps." Those just above small-caps are called "mid-caps."
Why would someone invest in a small-cap stock instead of a large-cap stock?
Small-cap stocks may offer more opportunities for investors and traders seeking capital gains. Because they are smaller companies, small-caps have more room to grow. As a company grows, its stock probably will, too. Therefore, if you pick the right company to invest in, you could make more money by holding a small-cap stock than a large-cap stock. However, in the real world, large-cap stocks are typically less risky than small-cap stocks, and they may also issue dividends that boost their total rates of return.