Small Cap Funds – Basics, Advantages and How To Invest

Want to invest in small-cap funds? Need more information before you plan to invest? This article will guide you in taking the best decision.

Investors in the market have categorised listed companies based on their market capitalisation value in large, mid, and small-cap. Small-cap companies have a market-cap value of Rs 5000 crore or less. As the name suggests, small-cap funds invest predominantly in small-cap companies but have great potential to grow to large-cap organisations and generate excellent returns for investors. Let’s learn about small-cap mutual funds, their features, and their investment profile.

What is a small-cap mutual fund?

First, let us understand ‘what is a small cap fund?’  

Small-cap funds are essentially equity funds that invest primarily in small-cap companies. The Securities and Exchange Board of India has listed the companies based on their market capitalisation value size. The first hundred companies in the list are large-cap companies with a market capitalisation of Rs 200,00 crore. Between 101 and 250 are the mid-cap companies. The small-cap companies are listed from 251 onwards. Small-cap fund managers constantly look for companies continually growing and outperforming the large-cap benchmark index. Small-cap fund managers invest in such companies with the probability of developing into large companies. However, investors investing in these stocks must note that small-cap companies are prone to market volatility; therefore, these funds are high-risk investments. 

Features 

Some of the notable features of small-cap funds are the following.

  • As per the SEBI mandate, small-cap funds invest more than 65 percent of the corpus in small-cap equities.
  • These companies generate more returns than large caps as there is more room for growth.
  • These funds tend to perform excellently in a bullish market. But they also come with higher risks and are prone to market fluctuations.
  • Small-cap funds tend to perform well in the long run. These companies need time to outshine the market. 

Who should invest in small-cap funds?

  • Individuals who can stomach higher risks can consider investing in small-cap funds. These funds invest around 65 percent of the fund in small-cap companies.
  • Investors with a long investment horizon can invest in small caps since these funds need time to outperform the market.
  • One must allocate a small portion of their corpus/portfolio in small caps for capital appreciation. Avoiding small caps might prevent you from earning magical returns.    

Things to consider before investing in small caps

Small-cap mutual funds carry considerable market risks, and investors must consider all the factors before investing.

Investment risk

The best small-cap funds will carry risk but, at the same time, will generate attractive returns. While choosing, you must select the best-performing funds against the market benchmark.

Returns on investment

Investment experts advise investors to allocate a small portion of their investors in small caps. These equities have considerable risks. But you might also miss great returns if you don’t invest in these stocks.

Investment costs

Experts advise considering all expenses as a good way to measure your net profit from investments. SEBI has fixed a fund’s cost ratio at 2.50%.

Investment objectives

When the market falls, even the best-performing small-cap funds lose in returns. Therefore, if you are investing in small-cap funds, invest with a long-term investment plan like a children’s education or retirement plan.

Taxation

Small-cap funds are equity investments. Hence, the returns are taxed per Capital Gain Tax rules. If you invest for less than one year, the capital gain is taxed at 15% small-term capital gain tax. 

Are small-cap funds better than large-cap funds?

  • Small-cap funds have usually outperformed the large cap funds and market benchmarks for the following reasons. 
  • Small-cap funds perform well during oil price recessions or low-interest rates.
  • Small-cap funds are made of specified stocks that aren’t overly diversified. Since they belong to a focused group, that helps them grow and outperform the market.
  • Small caps are less leveraged.

Benefits of small-cap funds 

High growth potential

Investments are made in young companies – start-ups with room for expansion. These companies grow faster and generate higher returns on investment. 

Undervalued assets

Small company stocks are undervalued because they are undiscovered. Small-cap funds are great investment options for investors who don’t mind taking higher risks. 

Diversification effects

Investment experts advise all investors to invest a small portion in small companies to help balance risk-reward trade-offs. 

Possibilities of M&A

With small companies, the options of m&a are very high. As a result, the value of these stocks can grow fast, impacting the returns of small-cap mutual funds.

Liquidity

 It is good for small-cap investors that these stocks are not frequently traded on the bourses. Hence, when the company announced its earnings, other investors tried to get these shares. 

Things to consider before investing 

Risks

Small caps are more volatile and carry higher risks than large and mid-cap funds. Small companies are less established and suffer when the market isn’t performing well.

Returns 

In a couple of years, when the market went through a bull phase, the small-cap category performed well, attracting many investors’ interest. Several of these small company stocks have turned multibagger. 

Cost

Small-cap funds charge an annual fee or expense ratio. SEBI has restricted the upper limit of the expense ratio to 2.25%.  

Investment horizon

Small-cap companies are susceptible to market volatility and experience a significant erosion in returns when the market goes downward. Hence, one must allow sufficient time for these stocks to generate expected returns. 

Financial goals

Small-cap funds are ideal for investors investing for long-term financial goals. Investors close to their retirement, looking to generate a steady source of income, or risk-averse shouldn’t opt for small-cap mutual funds.

Investors must research the best small-cap mutual funds before investing their money. 

Conclusion 

Now that we have explained small-cap fund meaning, you can invest in a fund that fits your overall financial objective. Small-cap mutual funds are excellent for portfolio diversification and generating handsome returns. 

Disclaimer: “This blog is exclusively for educational purposes and does not provide any advice/tips on Investment or recommend buying and selling any stock”.