Small-cap stock funds are typically categorized as funds composed of stocks issued by companies with market capitalizations of less than $500 million. Generally, they are small, emerging companies that concentrate on the development of a promising product or service. Small-cap companies may grow rapidly because of an expanding business sector.

Mid-cap funds are usually defined as those containing equities issued by firms with capitalizations between $500 million and $5 billion. They are generally well-established companies within their markets. Also, they may have more experienced management than their small-cap counterparts.

Mid-cap companies, however, may offer greater growth potential than large-cap companies whose capitalizations typically exceed $5 billion.

Theoretically, small-cap funds have greater long-term growth potential than mid-cap funds. A main reason is that the smaller, newer companies have the most room for expansion. However, small caps also carry greater risk. As not yet established companies, they are at risk for failure.

“History shows that small-cap stocks have outperformed large-cap stocks over time.  The amount of outperformance has depended upon on several factors, including, but not limited to time period, market capitalization, monetary policy, economic cycle, etc.   I consider the outperformance figures a rough estimate of what to expect in the future.  Smaller-cap indexes are relatively new and thus may not provide a long enough time frame in which to accurately assess the data.  Researchers have generally used data from stock exchanges to make comparisons between small-cap and large-cap performance. The 2006 Ibbotson Yearbook with data provided by the Center for Research of Securities Prices shows that from 1925 through 2005, stocks in the two smallest deciles of capitalization returned 12.0% and 14.0% respectively while stocks in the largest two deciles returned a geometric average of 9.5% and 10.9% respectively.”

Source: Small-Cap versus Large-Cap, Michael A. Weiss, 2007. Michael A Weiss is the editor of “The Mutual Fund Investor” which is a mutual fund research newsletter.

Comparing past performance with current market trends
Despite the overall record of those 17 years noted above, more recent performance illustrates a different picture. For example, consider the year-to-date total returns as of August 31, 2000:

Small-cap stocks: 7.33%
Mid-cap stocks: 23.05%
Large-cap stocks: 4.11%

Similarly positive results for small and mid-cap appear when you examine the annualized one-year total returns through June 30, 2000:

Small-cap stocks: 14.32%
Mid-cap stocks: 16.97%
Large-cap stocks: 7.25%

These figures show that mid-capitalized companies took the lead in 2000. During the same year, small caps fared considerably better than large caps. While past performance is not indicative of future results, these numbers do reflect a trend in favor of small and medium-sized stocks that are invested in small and mid-cap mutual funds. However, a look at short-term growth provides examples of market fluctuation.

During the years from 1994 through 1998, large caps outpaced the others categories. Excluding that period, none of the three groups outpaced each other for more than two consecutive years since 1982. In fact, the three groups usually traded the top spot every year.

When evaluating investment funds, market volatility is an important characteristic to consider. Again, look at the period between 1982 through 1999 to understand market volatility and risk. The Standard deviation among the three capitalization categories provides guidance on their volatility and risk levels. The following are the standard deviation percentages for the three market cap categories from 1982-1999.

Small-cap stocks: 16.42%
Mid-cap stocks: 14.63%
Large-cap stocks: 11.81%

The highest percentage or standard deviation number represents the greatest volatility. These percentages indicate that small-cap stocks were the most volatile, with mid caps slightly lower and large caps the least variable. Small capitalized companies are considered to be the most risky of the three caps, but have the potential for growth. Larger companies, however, can offer dividends and the potential to help balance the effects of price fluctuations on provide more consistent total returns over the long-term.