Reasons to Avoid Small-Cap Funds: Risks and Things to Consider

In summary

Small-cap funds invest predominantly in smaller companies and can offer long-term growth potential, but their prices can fluctuate significantly. They may not suit investors with short investment horizons or low tolerance for market losses.

• Small-cap companies rank 251st onwards by full market capitalisation.
• Small-cap funds generally carry a Very High Riskometer classification.
• A short investment horizon can make market fluctuations harder to manage.
• Economic downturns can affect smaller companies more significantly.
• Fund selection requires more than comparing recent returns.
• Your goals, time horizon, and ability to tolerate losses should guide the decision.

The Bajaj Broking website provides access to mutual fund investments, but selecting a small-cap fund requires you to consider your circumstances and the scheme's risks.

Small-cap funds are equity mutual funds that invest primarily in small-cap companies. Under the SEBI scheme categorisation framework, these schemes must invest at least 65% of their total assets in the equity and equity-related instruments of small-cap companies.

For mutual fund classification, small-cap companies are those ranked 251 onwards by full market capitalisation. The classification is based on the market-cap lists used by the mutual fund industry.

These companies are smaller than large-cap and mid-cap companies. Some have room to expand, enter new markets, or increase revenue. However, they can also have limited access to capital, smaller customer bases, and less stable earnings.

A small-cap fund spreads its investment across several companies. This reduces the effect of one company performing poorly, but it does not remove market risk. The fund’s net asset value, or NAV, can still fall sharply when small-cap stocks decline.

Whether you should invest in small cap funds depends on your goal, investment period, financial position, and ability to handle losses.

You should consider avoiding or limiting these funds for the following reasons:

• High volatility: Small-cap stocks can experience sharp price movements. A fall in the market can reduce the value of your investment quickly.
• Possibility of short-term losses: Small-cap funds can deliver negative returns over shorter periods. They may not suit a goal for which you need the money soon.
• Limited experience with market risk: New investors can be influenced by recent high returns. Understanding the different types of mutual funds can help you compare risk before selecting a category.
• Economic sensitivity: Smaller companies often have fewer financial resources. A slowdown, fall in demand, or increase in operating costs can affect their earnings.
• Sector rotation: Investors sometimes move money from riskier asset classes into relatively established companies. Such a shift towards large-cap funds can place pressure on small-cap stock prices.
• Fund-specific risks: Performance depends on the fund manager’s decisions, portfolio concentration, stock selection, and expense ratio.
• Business failure risk: Small companies can face stronger competition, financial pressure, and difficulty raising money. The risk relates to the underlying companies, not the mutual fund itself.
• Limited information: Smaller companies can receive less research coverage than established businesses. Fund managers can therefore have fewer public information sources for evaluating some companies.
• Liquidity risk: Some small-cap stocks have low trading volumes. A fund may find it difficult to buy or sell large quantities without affecting the stock price.
• Valuation risk: A company’s share price can rise faster than its earnings. If expectations are not met, the price can correct sharply.

Small-cap funds are not unsuitable for every investor. However, they require the financial ability and patience to tolerate market falls without needing to redeem at an unfavourable time.

You can invest in small-cap funds digitally through the Bajaj Broking website. Complete these steps:

1. Complete your KYC: Provide the required identity and address information. Know Your Customer verification is mandatory before investing.
2. Open your account: Create an account on the Bajaj Broking website after completing the required verification.
3. Review available schemes: Compare their investment objectives, portfolios, expense ratios, exit loads, performance histories, and Riskometer categories.
4. Select the investment mode: Choose an SIP or a lumpsum investment. The minimum SIP amount starts from Rs. 100 for eligible schemes.
5. Enter your investment amount: Select the amount and, for an SIP, the payment frequency.
6. Complete the payment: Use an available digital payment method to place the investment order.
7. Track your investment: Use Dashboard, Portfolio, Orders, and MF Profile to review your holdings and transactions.

Do not select a scheme only because it recently delivered high returns. Mutual fund returns are market-linked, and the value of your investment can rise or fall.

Before investing, assess your finances and the purpose of the investment. Review the following factors:

• Financial objective: Connect the investment to a specific goal. Small-cap funds should not be selected merely because they delivered strong recent returns.
• Investment horizon: Small-cap funds require a long-term approach because they can take time to recover from market falls. There is no fixed period that guarantees positive returns.
• Tax treatment: Small-cap funds are generally treated as equity-oriented mutual funds for taxation when they meet the required equity allocation. Tax depends on the applicable law and your holding period.
• Performance across market cycles: Do not judge a fund using one year of returns. Review its performance during both rising and falling markets.
• Benchmark comparison: Compare the fund with the benchmark stated in its scheme documents. A benchmark comparison should cover similar periods and should not be limited to one market phase.
• Risk tolerance: Consider how you would react if the investment value fell sharply. Selling during a market fall can turn a temporary decline into an actual loss.
• Emergency needs: Avoid investing money that you might need for immediate expenses. Small-cap funds can be at a low value when you need to redeem.
• Portfolio balance: Check how much of your total portfolio is already invested in equity and other high-risk assets.

For example, suppose Rakesh needs Rs. 3 lakh for college fees in two years. A sharp fall near the payment date could leave him short of his goal. A small-cap fund may not match this short investment period.

Choosing a small-cap fund requires more than comparing recent returns. The following checks can help you evaluate a scheme:

• Check portfolio diversification: Review whether the fund invests across companies and sectors. Heavy concentration can increase the effect of one sector performing poorly.
• Evaluate the fund manager: Review the manager’s experience, investment approach, and performance across different market conditions.
• Compare similar funds: Compare expense ratios, exit loads, portfolio concentration, risk levels, and long-term consistency. Use the scheme’s stated benchmark instead of assuming that every fund follows the same index.
• Focus on consistency: A short period of high returns does not prove that a fund will perform well in the future.
• Review the Riskometer: The Securities and Exchange Board of India (SEBI) Riskometer ranges from Low to Very High. Small-cap equity funds generally carry a high level of market risk, but you should check the current scheme label.
• Read the scheme documents: Review the investment objective, asset allocation, risk factors, expense ratio, and exit-load conditions.
• Check portfolio overlap: If you already hold another equity fund, compare their portfolios. Owning two funds with many of the same stocks provides less additional diversification.

There is no single “best” small-cap fund for every investor. A suitable choice depends on your financial goal, investment period, portfolio, and ability to accept market fluctuations.

Small-cap funds offer exposure to smaller companies, but they also carry high volatility, liquidity risk, and the possibility of prolonged losses. They may not suit short-term goals, emergency savings, or investors who are uncomfortable with sharp changes in value.

Before investing, assess the fund’s portfolio, expenses, benchmark, Riskometer category, and past performance across different market conditions. You can explore options for investing in mutual funds through the Bajaj Broking website. You can invest through a lumpsum payment or SIPs, depending on the scheme and your investment plan.