Everything You Need to Know about Small-Cap Funds

 

When categorized based on market capitalization, equity funds fall into one of the three types – large-cap, mid-cap, and small-cap.

Small-cap equity funds involve putting money in small-cap companies with a lot of room for growth. This means you can expect exceptional return potential but also be ready to face a higher level of risk.

In this guide to small-cap funds, we try to understand what they are, how they work, who should invest in them, and what benefits and features they offer. For a further deep-dive on the nuances of small-cap funds, please refer to this guide from PGIM.

What Are Small-Cap Funds?

As mentioned earlier, small-cap funds invest in stocks of publicly traded companies that have a market capitalization of Rs. 5000 crore or less.

On stock indices, small-cap companies often rank below 250 on the list by market cap. These are small and relatively new ventures focused mostly on aggressive expansion.

Small-cap funds try to leverage the growth potential of these companies by putting money in them when their capitalization is still small. These funds have a higher potential for returns as compared to mid and large-cap funds. However, such companies are more likely to incur losses during adverse market conditions.

This means, while small-cap funds offer outstanding return potential, they have a higher risk level than mid and large-cap funds. Most fund managers invest about 65%-90% of the portfolio in small-cap stocks.

Features of Small-Cap Funds

Here are the primary features of small-cap mutual funds.

Risk-reward ratio – Small-cap funds carry a higher risk than mid and large-cap funds. When the market does not perform well, these funds suffer a lot because they are not well-established and can move out of business.

However, these make an excellent option for those who can tolerate high risk and want to benefit from aggressive growth.

Returns – This small category has performed really well in the market in the past few years and has attracted a large number of investors.

Small-cap funds are known to generate substantial returns and outperform other funds over the long term.

Asset allocation – According to the rules of the SEC (Securities & Exchange Board of India), small-cap funds must allocate at least 65% of the investment portfolio to small-cap stocks.

Taxability – Short-term capital gains earned on holding these funds for less than a year are taxed at 15% regardless of the realized amount. A tax of 10% is applicable on gains over Rs. 1 lakh made from holding these funds for over a year.

Benefits of Small-Cap Funds

Here are some of the primary reasons investors prefer small-cap funds.

High Returns Potential – Small-cap companies generally have an aggressive growth and expansion strategy that can significantly increase their market cap over the long term. This means the potential for returns is quite high in small-cap funds.

Many small-cap funds have averaged a return of 60% in 2021, with a few providing returns in excess of 100% during the year.

Diversification – The best small-cap funds typically invest in companies with a huge potential to generate returns.

Managers consider researching the market to put money in companies across sectors, adding a lot of diversifications to your portfolio.

Outperforming Other Funds – If mid-cap and large-cap funds don’t deliver expected returns, small-cap funds are a great inclusion in the portfolio. As they tend to offer better gains, they balance your portfolio.

Who Should Invest in Small-Cap Funds?

Small-cap funds are more suitable for those with a long-term investment horizon. Such funds suffer a lot when the market dips.

So, to allow the funds to generate returns as per your expectations, you should stay invested for a longer term. Moreover, these funds are highly volatile and risky, so they are an ideal investment for those who have good risk tolerance.

Small-cap funds are good options for investors with long-term investment goals like retirement planning, children's education, or medium-term debt repayment. Investors can put money in small-cap funds in one of the two ways – lump sum and SIP (Systematic Investment Plan).

In the first route, you can invest the total amount in one go. SIP allows investors to allocate funds to a scheme on a monthly or quarterly basis.

Now that you know what small-cap funds are, how they work, their features and benefits, you can decide whether you should invest in them or not, depending on your goals and risk tolerance levels.