Small Cap Mutual Funds and Benefit of Investing in These Funds

Small-cap mutual funds invest in stocks of small-sized companies, often referred to as small-cap stocks. These companies typically have a market capitalization lower than larger companies, making them relatively smaller in terms of total market value. Investing in small-cap mutual funds can offer potential for higher returns, but it also comes with higher volatility and risk. Here are some key points to consider when looking into small-cap mutual funds:

What are Small Cap Funds?

Small cap funds are the funds which invest in small companies which has high potential for growth. Typically the companies having a market capitalization of ₹ 5000 crore or less are called small cap companies. However as per SEBI, the definition of small cap companies is different. If we arrange all the companies listed in the Index in descending order of market capitalization, the first 100 stocks will be known as large cap stocks. Another 101 to 250 rank companies will be classified as mid cap companies. Rest of the companies are treated as small cap companies. The small cap mutual funds invest in such companies.

Features of Small Cap Funds

(1) Small cap funds invest large proportion of their funds in small companies.

(2) Small cap funds are riskier as compared to large and mid-cap funds as the performance of small companies may very up to a large extent in the long run.

(3) Small caps typically outperform in the long run as compared to the large cap or mid cap funds as there is more growth potential in small companies in the long run.

Some Good Small Cap Funds in India

Things to keep in mind while considering small cap funds

Risk and Volatility

Higher Risk: Small-cap stocks tend to be more volatile and can be riskier than larger, more established companies.

Potential for Higher Returns: The higher risk is often associated with the potential for higher returns.

Diversification

Diversify Portfolio: Small-cap mutual funds can add diversification to a portfolio that may be dominated by larger companies.

Research and Due Diligence

Fund Manager Track Record: Investigate the track record and experience of the fund manager managing the small-cap mutual fund.

Fund Performance: Analyze historical performance, considering both short-term and long-term results.

Expense Ratios

Low Expense Ratios: Look for funds with reasonable expense ratios to minimize the impact on returns.

Investment Goals

Align with Goals: Ensure that the investment objectives of the small-cap mutual fund align with your financial goals and risk tolerance.

Long-Term Horizon

Patience is Key: Small-cap stocks may take time to mature and deliver returns. A long-term investment horizon is often recommended.

Review Portfolio Regularly

Monitor and Rebalance: Regularly review your portfolio and rebalance if necessary to maintain the desired asset allocation.

Fund Size

Consider Fund Size: Be cautious of very small funds as they may face liquidity challenges.

Exit Strategy

Have a Plan: Determine your exit strategy, especially if investing for a specific financial goal.

Tax Implications

Understand Tax Consequences: Be aware of potential tax implications, especially in terms of capital gains.

Professional Advice

Consult a Financial Advisor: Consider seeking advice from a financial advisor to ensure that small-cap mutual funds fit well into your overall investment strategy.

Benefits of Investing in Small Cap Mutual Funds

You have the potential to earn high returns and better the large cap funds by a huge margin. Small cap funds invest in smaller companies with substantial growth potential. We have seen in the past how companies like Britannia, Lupin and Titan went from being small caps to large caps creating billions of wealth in the process. In the future, such smaller companies could become mid-cap or large-cap companies. In short, the returns potential is very high in small-cap funds.

Most of the small cap stocks are avoided by large institutions due to lack of liquidity. This allows the stock to move on the strength of its own merits. So, the chances of organic price rise are higher in such companies.

In portfolios dominated by large cap and index companies, these small cap stocks offer the much needed Diversification of risk. These small cap funds invest your money in companies from different industrial sectors like IT, banking/financial, automotive, FMCG, and more. Also, small cap stocks tend to less correlated to the index stocks, making them a better diversification bet.

How to Know if the Small Cap Funds are Suitable for You?

These small cap funds are suited to aggressive investors with a long-term investment horizon only. Small cap funds also call for higher risk appetite

Small cap funds are best suited to investors with an appetite for portfolio value fluctuations and hence it is best to have only a small exposure to small cap funds

More than investing in lumpsum, these small cap funds are ideal if you are investing via systematic investment plans or SIPs. Here the rupee cost averaging works in your favour and reduces your cost of holding.

Finally, ensure that these small cap funds are not more than 10-15% of your equity exposure and they actually fit into your long term goals. That is the real acid test for small cap funds.

Conclusion

Remember that while small-cap mutual funds can offer growth potential, they may not be suitable for every investor. It’s crucial to carefully assess your risk tolerance, investment goals, and time horizon before investing in any mutual fund, including those that focus on small-cap stocks.

Also read: Know About Mutual Funds and their Features