Reasons to avoid investing in Small Cap Funds

Investors may avoid Small Cap Funds due to their higher risk, volatility, and susceptibility to economic downturns.
EXPLORE FUNDS
Reasons to avoid investing in Small Cap Funds
EXPLORE FUNDS
3 min
24-May-2024

When it comes to investing in small-cap funds, it's crucial to recognize their high level of risk and volatility. These companies are particularly vulnerable to market fluctuations and economic downturns. Due to their size, even minor shifts in the market or industry can greatly impact their stock prices.

Should you invest in small-cap funds?

There are a plethora of small cap funds to invest in available in the market, but they also come with certain risks. So, to decide if you should invest in small-cap funds, consider the following:

  • Risk: Small-cap funds to invest in are fraught with risk, and it has often been seen that investments in them over the short term have led to short-term losses. Hence, those who are totally opposed to negative returns on their investments need to refrain from investing in small-cap mutual funds always.
  • Caution for New Investors: It is always advisable for new investors not to be swayed by higher returns. Rather, the new investor would do well to invest in mutual funds belonging to other categories. Once they learn the nuances of different types of mutual funds and their respective performances, they can start exploring small-cap funds.
  • Short-Term Investors Beware: Another critical factor to bear in mind when you ask should we invest in small-cap mutual funds is that for investments over a short duration, small-cap mutual funds are best avoided. Since small-cap funds to invest usually perform as per expectations over longer periods, they can be equally volatile in the short run. Hence, you may incur losses if you wish to withdraw or redeem your investment from the said small-cap mutual fund. Of course, that is not to say that gains cannot be made, but the risk always looms. That’s why it always pays to stay invested in a small-cap fund for at least five to six years.
  • Overall Economic Conditions: Economic conditions significantly impact small-cap stocks since such companies are often more sensitive to business cycle changes. Recessions or economic downturns usually affect small-cap companies, resulting in their stock and fund prices declining.
  • Sector Rotation: The average investor tends to rotate his investment out of specific asset classes or sectors into others on changing investment themes or market conditions. Hence, a shift from small-cap funds to large-cap funds may result in small-cap funds underperforming.
  • Fluctuating Interest Rates: Radically changing interest rates usually affect small-cap fund performance. Spiralling interest rates increase the borrowing costs for small-cap funds, consequently affecting their stock prices and profitability.
  • Fund-Specific Factors: Small-cap funds are also affected negatively by poor fund management, inappropriate investment strategies, higher expense ratios, and portfolio composition. So, when they underperform, investors usually redeem their shares, resulting in outflows and declining fund assets.
  • Significant Failure Rates: Small-cap funds have failed in the past, losing out to stiff competition, acceptance in the market, financial instability, and stringent regulatory compliance. Hence, investing in such funds is riskier due to higher probabilities of underperformance that could lead to losses.
  • Instability and Limited Resources: Small-cap funds usually have limited resources, lower visibility in the market, and track records that are less established compared to larger and more established companies. So, should you invest in small-cap funds, do bear in mind that they are likely to face challenges like limited capital access, spiralling borrowing costs along with difficulties in attracting professional talent. Moreover, small-cap funds are vulnerable to economic downturns and changing business cycles, which certainly make them risky investments.
  • Challenges About Information & Research: Small-cap funds are usually overlooked by financial analysts and the media when compared with large-cap funds. Consequently, the information needed by investors can be limited, and this makes it all the more challenging in conducting thorough analysis and research. Lack of this required information may, therefore, increase the risks of putting your money into small-cap funds, as the average investor has less visibility on the fund’s fundamentals, growth prospects, and competitive position.
  • Technical Factors: Even though several small caps to invest exist, investing in them can be risky due to certain technical factors like trading volumes, shifting investor sentiment, and market overvaluation that may also influence small-cap fund performance. For instance, when a small-cap fund becomes overvalued concerning its growth prospects and earnings, it may correct, resulting in declining values.

Summary

So, the next time you ask, should we invest in small cap mutual funds, or want to start your investment journey, you may visit the Bajaj Finserv Mutual Fund platform to know more about mutual funds and SIPs. Use its SIP and Lumpsum Calculator to calculate your financial goals better.

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Frequently asked questions

Why not to invest in small-cap?
-Small-cap is known for its volatility or sharp price fluctuations leading to greater uncertainty and risk for investors. Moreover, they also have liquidity concerns, limited resources and stability, and higher rates of failure.
What is front end load and back-end load?
-Front-end and back-end loads are defined as fees or sales charges imposed by mutual funds on investors as they buy or sell shares. Such fees are charged extra to pay the fund's sales professionals or distributors and are not a part of the operating expenses of the fund.
What are the problems with small-cap stocks?
-The main problems are extreme volatility or sharp price fluctuations, an absence of liquidity, limited resources like capital that may lead to bankruptcy, limited diversification, wider bid-ask spreads owing to lower trading volumes, and vulnerability to market manipulation.

Why small-cap funds are falling?
The main reasons small-cap funds are falling are shifting market sentiments, oversensitivity to economic downturns, sector rotation, spiralling interest rates, investors' abrupt profit booking, and other management issues or regulatory problems that lead to fund prices declining.

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