Small-Cap Mutual Funds - Meaning, How to Invest and Benefits

Explore more about what small-cap funds are, their types, and why you should invest in them.
3 mins
03 August 2023

Small-cap mutual funds are one of the most aggressive mutual funds. These mutual funds are an investment option that invests in small-cap companies, which are all the companies after the top 250 in terms of market capitalisation. Managed by professional fund managers, small-cap mutual funds invest primarily in stocks and can potentially yield higher returns than traditional investment options. However, they are considered to be riskier as smaller companies are more vulnerable to market fluctuations and economic downturns.

Investing in small-cap mutual funds can be a great way to diversify your portfolio. It is important to research its past performance, the experience of the fund manager, the expense ratio, and the risks involved before choosing a small-cap fund. Be prepared to accept the ups and downs of the market and have a long-term investment horizon.

How Does Small-Cap Funds Work?

Small-cap mutual funds operate by primarily investing a significant portion, typically a minimum of 65%, of their portfolios in small-cap stocks. Small-cap stocks are those associated with companies that have a smaller market capitalization, making them relatively riskier investments. However, these stocks also offer the potential for higher returns, which attracts investors willing to accept higher volatility in exchange for the prospect of positive long-term growth.

The composition of the fund's portfolio is a critical factor in the functioning of small-cap funds. Skilled fund managers carefully select small-cap stocks, with an emphasis on companies not typically found among the top 250 in terms of market capitalization. This strategy allows the fund to focus on lesser-known businesses with substantial growth potential.

How are small-cap funds different from mid-cap or large-cap funds?

The difference between large-cap, mid-cap, and small-cap mutual funds lies in the size of the companies that they invest in, which affects their potential risk and return.

  1. Large-cap mutual funds invest in companies with a large market capitalisation, typically these are the top 100 listed companies, for example, Nifty 100 stocks. This means they are typically more established and stable than smaller companies. As a result, large cap funds tend to offer lower risk and lower potential for returns.

  2. Mid-cap mutual funds invest in stocks of mid-sized companies that are considered developing companies, typically in companies that are ranked between 101 to 250 on the basis of market capitalisation. These companies are riskier than large-cap companies, but less risky than small-cap stocks. Mid-cap funds aim to offer a balance between risk and return, offering moderate growth potential while still providing some level of stability.

  3. Small-Cap is a term used for companies with a relatively small market capitalisation, typically these companies are ranked after 250. Performance of these are generally more volatile and risky, but with greater potential for growth. Small cap funds aim to offer high growth potential but with a higher level of risk.

It is important to know that small-cap mutual funds may not hold as diversified a portfolio as mid-cap or large-cap funds. Mid-cap and large-cap funds tend to offer greater diversification across different sectors and industries, reducing the overall risk of the portfolio.

Benefits of Investing in a Small-Cap Fund

  1. High Growth Potential: Small-cap stocks have the potential for significant growth. These companies are often in their early stages of development and can experience rapid expansion, translating into higher returns for investors.

  2. Diversification: Small-cap funds typically hold a diversified portfolio of stocks from various sectors and industries. This diversification can help spread risk across different companies, reducing the impact of poor performance by any single stock.

  3. Undervalued Opportunities: Smaller companies may be undervalued or overlooked by institutional investors, creating opportunities for individual investors to identify hidden gems before they gain widespread attention.

  4. Alignment with Risk Tolerance: Investors who are comfortable with higher risk levels and have a greater risk appetite may find small-cap funds appealing. These funds can align with the investment goals and risk tolerance of such individuals.

Let us talk about taxes!

It is important to consider the tax implications of any gains made through these investments. The tax treatment on mutual fund gains depends on the type of mutual fund and the holding period.

If the investments in Equity-oriented mutual funds, like small-cap mutual funds are held for more than 1 year, they are subject to a Long-Term Capital Gains (LTCG) tax of 10% on gains exceeding Rs. 1 lakh provided such units are subject to Securities transactions Tax (STT) @. For example, let us consider if an investor holds a small-cap mutual fund for more than a year and sells for a profit of Rs. 2 lakhs, the LTCG tax of 10%# will be levied on the Rs. 1 lakh exceeding the threshold limit, resulting in a tax liability of Rs. 10,000.

The Short-Term Capital Gains (STCG) tax rate applicable to gains made on equity-oriented mutual funds held for less than a year is 15%#.

Note:
# The rates mentioned above are excluding cess and surcharge if any.
@ STT is lieved on the sale of units of equity oriented mutual fund at the rate of 0.001%.

It is important to note that there are also tax implications on mutual fund dividends. Dividends received from mutual funds are subject to TDS of 10%*, which is paid by the mutual fund company. * Tax is not deductible if income in respect of units of a mutual fund is below Rs. 5,000 in a financial year.

Conclusion

Small-cap mutual funds are high-risk and high-reward investment options that can provide investors with potentially higher returns compared to mid-cap or large-cap mutual funds. However, they are not suitable for those who are uncomfortable with volatility and prefer to invest in the long term. With thorough research, analysis, and consideration of investment goals and risk profile, investors can choose the right small-cap mutual fund that aligns with their financial objectives and achieve higher returns.

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