Small Cap Mutual Funds

Small-cap mutual funds are invested in companies that are below the top 250 stocks in the exchange as per their market capitalisation.
Small Cap Mutual Funds
3 mins
05-June-2024

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.

Read on to know about small-cap mutual fund definition, small-cap mutual fund features, and how small-cap mutual fund works.

What is a small-cap mutual fund?

A Small-Cap Mutual Fund is a type of mutual fund that primarily invests in stocks of companies with relatively small market capitalisations. These companies are often considered to have significant growth potential but may also carry higher risk due to their smaller size and potential volatility. Small-cap mutual funds aim to provide investors with the opportunity for high returns over the long term by investing in small, rapidly growing companies that may become future market leaders. These funds typically suit investors with a higher risk tolerance seeking capital appreciation over time.

How does a small cap mutual fund 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.

Features of small-cap mutual funds

Here are some features of small-cap mutual funds:

  • Focus on small-cap stocks: Small-cap mutual funds primarily invest in stocks of companies with relatively small market capitalisations, typically below a certain threshold set by the fund manager or market indices.
  • Growth Potential: These funds target companies with high growth potential, aiming to capitalise on their ability to outperform broader market indices over the long term.
  • Higher risk-reward profile: Small-cap stocks are often more volatile and carry higher risk compared to large-cap or mid-cap stocks. Consequently, small-cap mutual funds have a higher potential for returns but also come with increased risk.
  • Diversification: To mitigate risk, small-cap mutual funds typically hold a diversified portfolio of small-cap stocks across various sectors and industries. Read more about, What is portfolio diversification.
  • Active management: Due to the dynamic nature of small-cap stocks and the need for thorough research, many small-cap mutual funds are actively managed by experienced fund managers who actively select and manage the portfolio to maximise returns.
  • Long-term investment horizon: Investors in small-cap mutual funds should typically have a long-term investment horizon, as these funds may experience short-term volatility but have the potential for significant growth over time.
  • Liquidity concerns: Small-cap stocks may have lower liquidity compared to larger companies, which can affect the ability to buy or sell shares quickly without impacting the stock price. Fund managers need to consider liquidity when managing the portfolio.
  • Potential for alpha generation: Skilled fund managers may be able to generate alpha, or excess returns, by identifying undervalued small-cap stocks that have the potential to outperform the broader market.

What are the advantages of investing in small-cap mutual funds?

Here are some advantages of investing in small-cap mutual funds:

  • Potential for high growth: Small-cap funds allocate investments to companies in early growth stages with significant growth potential. By investing in these funds, you tap into the potential growth trajectory of these companies, which can boost your returns as their stock prices appreciate over time.
  • Portfolio diversification: Adding small-cap funds to your investment portfolio provides diversification benefits, as the small-cap segment offers a vast array of investment opportunities compared to large and mid-cap segments. These funds spread investments across various companies and sectors, enhancing portfolio diversification.
  • Overlooked by institutional investors: Small-cap stocks often fly under the radar of large institutional investors, creating opportunities for organic growth. Limited attention from analysts and institutions can lead to undervaluation of small-cap stocks, enabling fund managers to capitalize on investments in hidden gems.

Who should invest in small-cap mutual funds?

Type of Investor

Description

Long-term investors

Investors with a time horizon of seven years or more can benefit from small-cap investments, despite short-term volatility. Over the long term, small-cap funds have the potential to deliver significant returns as they invest in emerging businesses poised for growth.

Diversification seeker

Adding small-cap funds to your portfolio provides diversification advantages. These funds invest in early-stage businesses across various sectors, reducing overall portfolio risk while maximising potential returns. Investors seeking exposure to different market segments can allocate a portion of their portfolio to small-cap funds.

Risk tolerance

Small-cap stocks typically exhibit higher volatility compared to large-cap stocks. Investors with a higher risk tolerance and a willingness to capitalise on market fluctuations may find small-cap funds suitable for their investment objectives.

High growth aspirations

Small-cap stocks offer the potential for rapid growth as they invest in early-stage companies. Investors seeking high growth opportunities and are comfortable with higher volatility may consider allocating a portion of their portfolio to small-cap funds.

 

The checklist for investing in small-cap funds

Checklist Item

Details

Focus on historical performance

Keep a close eye on the consistent performance of small-cap funds over the past few years. Unlike large caps, small caps exhibit greater volatility, making them less susceptible to business cycles. These funds employ a bottom-up stock selection approach for such stocks. Hence, sustained performance over several years can signal excellent prospects.

Assess risk-reward ratio

Ensure that the potential returns justify the risks involved. Opt for small-cap funds that outperform the Nifty and Sensex indices.

Evaluate liquidity

Evaluate the liquidity of the fund. CRISIL provides liquidity scores for large, medium, and small-cap mutual funds. The liquidity score indicates the number of days required for a fund manager to liquidate the entire portfolio without adversely impacting the prices. Lower liquidity ratios are preferable.

Verify management stability

Verify the stability of the fund management team. Consistency in fund management is crucial for sustaining performance. Frequent changes in management should be avoided in the case of small-cap mutual funds.

Consider performance during bear markets

Assess how the fund performs during bear markets or downturns. Small-cap funds exhibit varying levels of volatility and performance during such periods. While they typically excel in bullish markets, superior performance during a recession can set a fund manager apart.

Account for availability of quality stocks

Keep in mind the limited availability of high-quality small-cap stocks in the market. This scarcity should be considered when allocating funds to small-cap stocks.

Taxation rules of small-cap mutual funds

  • Holding period: The tax treatment of capital gains from small-cap mutual funds depends on the investment holding period.
    • Short-term capital gains (STCG): If you redeem your units within 1 year of investment, the gains are taxed at a flat rate of 15%.
    • Long-term capital gains (LTCG): If you hold your units for more than 1 year, long-term capital gains exceeding Rs. 1 lakh are taxed at 10%. Any LTCG below Rs. 1 lakh is exempt from taxation.

Things investors should consider before investing in small cap funds

Small-cap mutual funds offer the potential for high returns, but they also come with inherent risks. Here's a breakdown of factors to consider before investing:

Risk tolerance

Small-cap stocks are inherently more volatile than large-cap stocks. Be honest about your comfort level with potential losses.

 

Investment goals

Align your investment horizon with small-cap funds. They are suitable for long-term goals (7-10 years) like retirement or child education where you can ride out market fluctuations.

 

Expected returns vs. risk

While aiming for high returns, don't solely focus on past performance. Compare potential returns with the level of risk involved. Consider choosing funds with a history of outperforming the small-cap benchmark and peers while managing risk effectively.

 

Investment costs

Mutual funds charge an expense ratio to cover management fees. Choose a fund with a competitive expense ratio to maximize your net returns (returns after expenses).

 

Tax implications

Understand how capital gains are taxed based on the holding period (investment duration). Short-term capital gains (less than 1 year) are taxed at 15%, while long-term capital gains exceeding Rs. 1 lakh (held for over 1 year) are taxed at 10% on the excess amount.

 

Choosing the right fund

Look beyond just the expense ratio. Consider the fund's overall track record, risk management strategies, and alignment with your investment goals. Consulting a financial advisor can help you navigate these factors and select the best small-cap fund for your needs.

Conclusion

In conclusion, small-cap mutual funds offer investors an avenue for potentially lucrative returns, albeit with higher volatility. These funds cater to a diverse range of investors, from those seeking long-term growth to those aiming to diversify their portfolios. While small-cap investments may carry increased risk, they also present opportunities for capitalising on market inefficiencies and discovering hidden gems. With careful consideration of individual risk tolerance and investment objectives, small-cap mutual funds can play a valuable role in achieving long-term financial goals.

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Frequently asked questions

What are small cap mutual funds?

Small-cap mutual funds are investment vehicles that primarily invest in stocks of small-cap companies. Small-cap companies are those with relatively small market capitalisations, typically falling within the bottom tier of the stock market in terms of size. These funds aim to generate capital appreciation by investing in the growth potential of small-cap companies.

Is small cap investing good?
How to select a small-cap fund?

When selecting a small-cap fund, investors should consider factors such as historical performance, fund management team expertise, investment strategy, expense ratio, and portfolio composition. Additionally, assessing the fund's risk-adjusted returns and comparing them with relevant benchmarks can provide insights into its performance consistency and suitability for investment.

When to buy small cap mutual funds?

The timing of buying small-cap mutual funds depends on various factors, including market conditions, investment goals, and individual risk tolerance. Investors may consider buying small-cap funds during market downturns or when valuations are relatively attractive. However, it's crucial to maintain a long-term investment horizon and avoid trying to time the market.

How to invest in small caps?

Investors can invest in small caps through small-cap mutual funds, exchange-traded funds (ETFs), or directly purchasing individual small-cap stocks. Mutual funds and ETFs offer diversified exposure to a basket of small-cap stocks, providing a convenient way to invest in this asset class with reduced risk compared to individual stock selection.

Should I invest in small caps now?

The decision to invest in small caps depends on individual investment objectives, risk tolerance, and market outlook. While small-cap investments offer higher growth potential, they also entail higher risk and volatility. Investors should carefully assess their financial goals and risk appetite before deciding to invest in small-cap funds.

How long should we hold small-cap fund?

The ideal holding period for a small-cap fund depends on individual investment goals, market conditions, and fund performance. Generally, investors should maintain a long-term perspective when investing in small-cap funds to weather short-term market fluctuations and benefit from the growth potential of small-cap companies.

When to sell small-cap mutual funds?

Deciding when to sell small-cap mutual funds depends on various factors, including changes in investment objectives, fund performance, market conditions, and individual financial circumstances. Investors may consider selling small-cap funds if their investment goals change, or if there are significant changes in the fund's performance or underlying fundamentals.

Why small cap funds give high returns?

Small-cap funds have the potential to deliver high returns due to the growth opportunities presented by small-cap companies. These companies often have higher growth rates compared to large-cap companies, which can translate into higher returns for investors. Additionally, small-cap stocks may be less efficiently priced, allowing skilled fund managers to uncover undervalued opportunities.

What is the future of small-cap mutual funds?

The future of small-cap mutual funds depends on various factors, including economic conditions, market trends, regulatory changes, and investor preferences. While small-cap funds offer attractive growth potential, they also face higher volatility and risk. Continued economic growth, technological advancements, and favorable market conditions may contribute to the growth of small-cap mutual funds in the future.

Can we have 2 small-cap mutual funds?

Yes, investors can have multiple small-cap mutual funds in their investment portfolio to achieve diversification and mitigate single-stock risk. However, it's essential to ensure that the chosen funds have different investment styles, objectives, and portfolio compositions to avoid overlap and maximize diversification benefits. Additionally, investors should consider their overall asset allocation and risk tolerance when selecting multiple small-cap funds for their portfolio.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.