Lux Investing

Are small (or even mid) cap fund returns limited because of market cap rules?

I've recently tried to learn more about stocks and investing., and I'm trying to get a better understanding of funds in my 401k. So if a fund is limited to stocks under a certain market cap, when stocks in that fund break the cap, are they dropped? Doesn't that defeat the purpose of the large gains/growth that small caps have potential for, at least as individual stocks? If they are dropped, aren't you missing out on the really large gains as some companies grow? So is a small cap fund's returns limited to the market cap of the stocks it holds? For example, I have some VSISX. If it holds the next Google, does the fund only benefit up to the point where it reaches the max market cap (about 2 billion I think), and not the remaining billions it may grow to?

Public Comments

1. They're replaced. Keeping them as their market cap increases may limit the return of the fund. As the market cap of a stock gets larger growth tends to level off, and so does risk.. Small cap stocks tend to grow faster and give high returns. But, they have higher risk and volatility too. So, the percentage of a portfolio that is in small cap stocks depends on an investors tolerance for risk.
2. In theory you might be correct. In practice I suspect that would seldom happen. You need to understand that Google was never a small cap. It started out as a large cap the day it went public. Same with MSFT. The other thing to take into account is that the largest holding of VSISX makes up only 0.25% of the portfolio, so even if one of those holdings does go gang busters it is not going to make a big difference in the overall performance of the fund.
3. Think of stock returns as a pyramid. On average, stocks fluctuate 2-3% daily. A 5% move is noticable. More stocks go up 10% than 20%, and so on all the way to the top - so the tenbaggers are an exception, and funds have enough 20-30% moves to work with to produce decent returns.
4. It's up to the digression of the fund manager as to when to buy and sell stocks. In a typical small cap fund, the manager usually has to buy stocks that are under the 2Billion market cap. Just because a stock grows past that 2B market cap does not mean the fund manager has to sell it. A lot of times they'll let some holdings grow and grow, as long as the outlook for the company remains good. According to morningstar.com, this fund has about 38% of it's funds in the mid-cap range, so they obviously don't sell when the market cap hits a certain limit.