Many studies have shown that small-cap stocks, while they involve a bit more risk, provide greater shareholder rewards. The expected returns of a stock portfolio increase as the market cap of those stocks decreases. Those who choose to invest in small caps can do so through various means, including selecting their own individual stocks (as we do in the Motley Fool Hidden Gems service) or through a mutual fund.

When you buy individual stocks, you'll know exactly what you're buying. You'll certainly know the number of shares you've purchased and their cost basis, plus any additional information you choose to research, which might include your company's exact market cap. Holding some small caps makes a whole lot of sense, but how narrowly should you define "small cap" when hoping to access those improved returns?

Reasonable minds can differ about where the line marking "small cap" is drawn. Like the oxymoronic "jumbo shrimp," there has to be a "biggest small cap." Some say the term applies to companies under $2 billion, some say $1 billion. Some particularly persnickety people have been known to plant a flag in the ground at $1.734 billion and get into knife fights over it. As a rule, it is wise to avoid those people.

But there's room for reasonable minds to differ. We can live with that.

So, apparently, can our government. Mutual funds can and do differ in how they define small cap as well. Although Securities and Exchange Commission (SEC) rules require that a mutual fund have 80% of its assets invested in the sector that is implied by its name (for example, 80% of funds must be in Latin American companies if it is called the Eastwood Latin American Fund), this rule does not extend to such words as small, large, value, or growth in a fund's name. The SEC has decided not to wade into the tricky area of defining what is or is not officially a small-cap or value stock.

This might explain what you own if you are a government employee and believe you are investing a lot of your retirement money in small-cap stocks through the government's retirement program. The Thrift Savings Plan (TSP) is the defined contribution plan for federal employees; essentially the federal employee 401(k). The plan is run with stunningly low expenses, includes up to a 6% employer match, and in general is a superb defined contribution plan. It provides five investment choices: a large-cap fund (C Fund), an International Stock fund (I Fund), a fixed-income fund (F Fund), a GIC Fund (G Fund), and the Small Capitalization Stock Index Investment Fund (pdf file) -- the "S Fund."

To determine how "small capitalization" is being implemented there, look at the fund's seven biggest holdings as of Dec. 31, 2004.

Company Capitalization
of Fund
Berkshire Hathaway (NYSE:BRKa) $131.5 3.08
Liberty Media Corporation (NYSE:L) $28.1 0.97
Genentech (NYSE:DNA) $83.0 0.86
DIRECTV Group (NYSE:DTV) $20.7 0.52
IAC InterActiveCorp (NASDAQ:IACI) $16.9 0.47
Juniper Networks (NASDAQ:JNPR) $14.1 0.46 (NASDAQ:AMZN) $14.6 0.44

These may well be nifty companies that have rewarded shareholders in the past, but what exactly are they doing in a fund advertising itself as the Small Capitalization Stock Index Fund?

The explanation here is that the "S Fund" is indexed to the Dow Jones Wilshire 4500, which is essentially all of the stocks in the market outside of the S&P 500. Because some very big companies are excluded from the S&P 500 index for various reasons, some enormous companies wind up in "the rest of the market." And therefore the supposedly small-cap S Fund.

According to Morningstar, in publicly available index mutual funds that track the Dow Jones Wilshire 4500 such as the Vanguard Extended Market Fund (VEXMX) or the Fidelity Spartan Extended Market Fund (FSEMX), a little less than 40% of assets are invested in small caps. About 5% of the DJW 4500 is invested in large caps, 2% is in "giant caps" and the majority, 53%, is in mid caps. So while a chunk of the S Fund is in small caps, most of it is invested in mid caps. Meaning, I suppose, that the fund could most accurately be called the "S & M Fund."

But I digress.

Over the long term, this methodology means an investment in the S Fund is unlikely to track the returns expected of small caps as measured by indexes such as the Russell 2000 or the S&P SmallCap 600. This doesn't mean that federal employees should avoid the S Fund -- again, it features very, very low expenses, and it does provide diversification beyond that available in the large-cap C Fund. It's just that when you invest in the S Fund, you're not really investing in small caps. At least not to the degree you might expect.

And that's not all that unusual. Plenty of mutual funds exhibit "style drift," though that isn't specifically the problem with the S Fund. However, if you have bought a mutual fund with the words "small cap" or something similar in the name, you may or may not really hold what you thought you were invested in.

If you believe you are investing in small caps through a mutual fund, do your homework to make sure the fund really is fully investing in smaller companies. Another alternative is to invest in individual small-cap stocks directly, in which case you'll always be able to know their market caps. If you're considering that, think about taking a free trial of Hidden Gems, which restricts its coverage to actual small caps and has the added benefit of having handily outperformed the market since its inception.

Bill Barker owns shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.