Honey, They Shrunk My Market Cap

In active portfolio management, size matters. Firms and asset managers often use company size -- usually market capitalization -- as a way to categorize companies.

For example, a firm could use a classification system like the one outlined below to determine how to allocate shares of a given-sized company among a range of portfolios adhering to different investment strategies. 

Trading places
Since the end of 2007, a relatively large number of companies have migrated down the market-cap food chain. Nano-cap firms have grown in number, and the median market cap has fallen dramatically. Consider some of these big movers:

So, how does a large-cap fund manager react when a holding like Citigroup (NYSE:C) temporarily becomes a mid cap, as it did last week? Conversely, what does a small-cap manager do when a company like Netflix (NASDAQ:NFLX) gains enough to elevate itself to mid-cap status?

The answer often lies in the fund prospectus. Some of the key factors to consider when looking at a fund's prospectus -- or a separate investment policy statement document -- include:

• Length of time a company has been in the new category (permanent or temporary)
• How the company's weighting affects the fund or portfolio's overall composition
• How much leeway the fund or portfolio manager has for investing in non-conforming assets

Typically, firm regulations and policies provide active fund managers with protocols for deciding what stays in and goes out of the portfolios they manage. Typically, such transactions are up to manager discretion, at least to some extent.

Time considerations
Often, firm policies include specific timing guidance. For instance, if a stock falls from large-cap to mid-cap, a policy might specify how long a large-cap manager can hold the stock, as well as how long a mid-cap manager has to wait before buying it.

Whatever the length of the specified time period, such guidelines aim to limit brokerage costs that would occur if a fund had to sell and rebuy an asset every time it crossed over category lines.

If a manager believes that a stock's movement into another bracket is temporary, another way to limit transaction costs involves using the futures market to neutralize the position until it returns to its former stature. If the move is permanent, the position can then be sold without penalty; however, other factors come into consideration.

Portfolio perspective
Compared to managers of passive index funds, actively managed funds often give managers more discretion to buy and sell holdings.

For instance, a large-cap growth mutual fund manager might have 20% breathing room when it comes to portfolio composition -- meaning that as long as no less than 80% of the fund consists of companies that fit the investment policy guidelines, the fund's strategy won't be compromised by holding a small amount of assets that don't fit the large-cap growth profile.

Still, since one stock typically doesn't affect the overall composition of a well-diversified fund, a manager may usually hold one or two stocks that don't fit the fund's stated strategy without breaching the investment policy statement. As long as the fund retains its fundamental characteristics from the perspective of the entire portfolio and adheres to the investment policy statement, a manager can usually get away with investing in a relatively small portion of non-conforming assets.

In practice
Some opponents of segmenting asset classes in this manner argue that the practice destroys value for retail investors, as brokerage fees incurred as a result of rebalancing will eat away at total returns. The practice of shuffling assets among funds owned by the same firm also draws criticisms of the status quo.

Now that the borders have been redrawn, investors can expect cameos by former large-cap companies in small- or mid-cap mutual funds, which would be bullish indicators that fund managers have expectations of their recovering their former glory. Keep an eye open for these and other signs that markets may be on their way to recovery.

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