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If you think your small-stock mutual fund invests in small companies, you might be in for a surprise. The typical fund really looks and behaves more like a mid-cap portfolio, according to a recent study.
Small companies commonly are defined as firms whose combined shares are worth less than $1 billion. Yet that threshold, which has been popularized through the efforts of fund researcher Morningstar Inc. of Chicago, is too high, says Scott Leonard of Leonard Capital Management in Santa Monica. That's because about 80% of all issues on the New York and American stock exchanges and Nasdaq fall below the $1-billion range.
A more realistic measure would define small companies as those with market values, or "capitalizations," of about $160 million or less, he says. Why that figure? It's roughly the median size of the smallest 20% of companies on the New York Stock Exchange.
The vast majority of mutual funds don't buy stocks this small. Leonard recently examined 3,661 domestic funds in Morningstar's database and found only 1% owned stocks that, on balance, have a median capitalization of $160 million or less. Even small-company funds usually troll for bigger fish.
Leonard believes proper classifications are critical for investors anticipating the higher returns and diversification benefits typically associated with small companies.
"If you are buying small-cap stocks [or funds] for the above reasons, smaller is better," he said.
One tip Leonard suggested: Seek out funds that bill themselves as "micro-cap" portfolios.
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