This post is about small cap funds and how you can leverage these versatile investment vehicles.  Every mutual fund has it’s own unique investing approach.  Some target certain sectors like technology or industrials.  Others target based on growth potential or fundamental value of a company.  And still others are based on the size of the company, like small cap mutual funds.

Stocks are categorized into sizes by market cap.  Also known as market capitalization, it is calculated by multiplying the outstanding shares by the share price.  This will give you the total value the market is giving to a particular company.  There are generally 3 cap size categories, large cap, small cap and mid cap.

Large cap stocks are ones with a market cap of over $10 billion.  Mid cap stocks are $2 billion – $10 billion.  And small cap stocks are ones that are valued at under $2 billion. There are also mega caps, micro caps and nano caps that are more narrowly defined.  These aren’t hard set definitions either.  It might fluctuate depending on who you talk to. But it’s the general idea.

So small cap mutual funds are ones that look for stocks with a market cap of less than $2 billion.  These are companies like AirTran Holdings (AAI) worth $760 million, Quest Software (QSFT) at $1.78 billion, WESCO International (WCC) at $1.66 billion in market cap.

There are two main ideas behind this strategy.  First is they are looking for growth.  Small stocks have the room and potential to grow fast and hot.  They are the most likely candidates to beat the market growth.

Secondly, these stocks go under the radar of most investors.  The reason is large institutional investors can’t own enough stock in a particular small company without owning controlling shares.  And if they own controlling shares, they have to go through regulators to get approval on such deals.  If they own any less than controlling shares, it’s really not worth their trouble because it’s not a significant enough to make a different in their gigantic portfolios.

Why is this important for other investors?  First of all, this takes large institutional investors out of competition for smaller investors.  If they were in the market for such stocks, good deals and lower share price would be much harder to come by.  This advantage is what small cap funds leverage to get their returns.

So in essence, fund managers investment strategy for these small cap growth funds are looking for companies that go under the radar at first, but has the potential to pop at some point in the future.  That is what they are looking for.  Money managers for these funds are looking for fast growth.

As a result of the potential for extraordinary growth, these funds also have the propensity to be very volatile.  These things go through massive ups and downs in the course of their existence.  Accordingly, you should be able to invest long enough to ride out the low points and give it a chance to recover if it goes through a valley.  In addition, if one of these investments go down the drain completely, the investor should have enough time to put capital elsewhere and try again.

Any investor looking to get in on small cap stock funds should consult their registered financial advisor for investment advice to see if this is an appropriate investment for them.  It’s not an investment for everyone.  It is associated with more risk than your typical stock investment.

In addition to small cap mutual funds, you can also find them in the form of ETF’s and index funds.  ETF’s, also known as exchange traded funds, are financial instruments that are traded just like normal stocks on the open exchange.  But they are baskets of stocks bundled into one security.

If you want to save some money on management fees, you can go with small cap funds that track indices.  These are passively managed funds that track a particular small cap index like the Russell 2000 index.  The Vanguard Small-Cap Index Fund is also a popular one to get and it has a corresponding ETF as well.