What Is Small Cap Fund

Small-cap mutual funds are investment funds that put at least 65% of their money into shares of small companies. These small companies are ranked 251st or lower based on their market size. The goal of these funds is to help investors earn higher returns by investing in growing businesses that have the potential to expand over time.
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Small Cap Mutual Funds
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3 mins
17-June-2026

Small Cap mutual funds are equity mutual funds that mainly invest in shares of small-cap companies, generally ranked beyond the top 250 companies by market capitalisation. These funds are managed by professional fund managers and aim to deliver long-term capital growth. As smaller companies have higher growth potential, small cap mutual funds can generate attractive returns over time. However, they also carry higher risk due to greater market volatility. Before investing in a small-cap fund, review its past performance, fund manager experience, expense ratio, and risk level. A long-term investment approach can help investors manage market fluctuations more effectively.

What is a small-cap mutual fund?

Small-cap mutual funds are a type of mutual fund that invests at least 65% of their assets in small-cap companies' equity and equity-related securities. These companies are ranked 251st and below in terms of market capitalisation. Small-cap funds are ideal for investors seeking long-term capital appreciation and are willing to take on higher risk due to the potential for greater volatility in smaller companies.

Small-cap funds generally have a market capitalisation of less than Rs. 5,000 crore. However, SEBI has refined the definition, categorising large-cap funds as those ranked within the top 100 companies by market cap. A key advantage of small-cap funds is their potential for higher returns, as smaller companies often have more growth opportunities than established large-cap firms.

How does a small cap mutual fund work?

  • Pooling of funds: Investors contribute money, which is combined into a single investment pool managed by a professional fund manager.
  • Investment in sustainable assets: The fund invests in companies, green bonds, and projects that focus on renewable energy, clean technology, sustainable infrastructure, and other environmentally responsible activities.
  • Diversification: Green funds spread investments across different sectors and industries to reduce risk while improving long-term return potential.
  • Active management: Fund managers regularly review the portfolio and adjust investments based on market conditions, company performance, and sustainability goals.
  • Performance monitoring: The performance of green funds is tracked regularly, helping investors assess returns and environmental impact.
  • Returns to investors: Investors may earn through capital appreciation and, where applicable, dividend distributions.
  • Fees and expenses: Green funds charge management and administrative fees, which can affect overall returns.
  • Redemption: Investors can redeem their units at the prevailing Net Asset Value (NAV), subject to the fund's applicable terms and conditions.

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.
  • 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?


  1. High growth potential
    Small cap companies are usually in the early stages of growth and have more scope to expand. As their business grows over time, their share prices may rise significantly, helping small cap mutual funds generate attractive long-term returns.
  2. Opportunity to invest early
    Investing in small cap mutual funds gives you exposure to emerging businesses before they become well-established. If these companies grow into industry leaders, early investors may benefit from significant capital appreciation over the long term.
  3. Potential for higher returns
    Small cap stocks have historically delivered higher returns than many larger companies over long investment periods. While market fluctuations can be higher, investors willing to stay invested may benefit from better wealth creation.
  4. Access to undervalued companies
    Many small cap companies receive limited attention from analysts and institutional investors. This creates opportunities for fund managers to identify quality businesses with strong growth potential before they become widely recognised.
  5. Professional fund management
    Most small cap mutual funds are actively managed by experienced professionals who research companies, monitor market trends, and adjust the portfolio when needed. This helps investors gain exposure to promising small cap businesses while benefiting from expert investment decisions.

 

Risks in small cap funds


  • Volatility. Small-cap fund prices can rise and fall sharply within a short period. While this creates opportunities for higher returns, it also increases the risk of losses. If you are not comfortable with frequent market movements, small-cap funds may not be the right choice for your investment portfolio.
  • Liquidity. Many small-cap companies have lower trading volumes than larger firms. During periods of market stress, selling these holdings can affect prices. To improve investor protection, SEBI has introduced stricter risk and liquidity disclosure requirements for small-cap funds.
  • Business fragility. Smaller businesses may face challenges such as limited customers, cash flow issues, weak corporate governance or high debt. These factors can affect business performance and reduce long-term investment value.
  • Recovery time. Following a major market correction, small-cap funds may take several years to recover and return to their previous peak levels.
  • Cost drag. Small-cap funds generally have higher expense ratios than index funds. Choosing Direct plans and comparing similar funds can help reduce investment costs.
  • Behavioural risk. Investing heavily after strong market gains or selling during market declines can reduce long-term returns. Following a planned asset allocation and rebalancing your portfolio regularly can help you stay disciplined and improve investment outcomes.

Who should consider investing in small cap mutual funds?

Type of InvestorDescription
Long-term investorsInvestors 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 seekerAdding 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 toleranceSmall-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 aspirationsSmall-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.

 

Who should invest in small cap mutual funds?


  • Growth-oriented investors: If your goal is long-term wealth creation and you are comfortable taking higher risks, small cap mutual funds can be a suitable choice. These funds invest in smaller companies that have the potential to grow rapidly, which may lead to higher returns over time.
  • Long-term investors: Small cap mutual funds can experience short-term price fluctuations. However, investors with a long investment horizon may benefit from the growth potential of emerging businesses as they expand over the years.
  • Diversification seekers: Including small cap mutual funds in your portfolio can improve diversification. They provide exposure to companies across different sectors and market capitalisations, helping create a more balanced investment portfolio.
  • Experienced investors: Investors who understand market cycles and can manage higher levels of risk may find small cap mutual funds suitable. These funds require patience, informed decision-making, and the ability to handle market volatility.
  • Investors with higher risk tolerance: If you are comfortable with market fluctuations and can stay invested during uncertain periods, small cap mutual funds may offer attractive long-term growth opportunities.
  • Investors seeking undervalued opportunities: Many small companies receive limited market attention, creating opportunities for long-term investors. Small cap mutual funds can help you gain exposure to such businesses with strong future growth potential.

The checklist for investing in small-cap funds

Checklist ItemDetails
Focus on historical performanceKeep 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 ratioEnsure that the potential returns justify the risks involved. Opt for small-cap funds that outperform the Nifty and Sensex indices.
Evaluate liquidityEvaluate 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 stabilityVerify 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 marketsAssess 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 stocksKeep 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

Investing in small cap mutual funds can generate capital gains and/or dividend income. As of 2025, here's how these earnings are taxed:

Capital Gains Tax

Capital gains refer to profits made when you redeem (sell) your small cap mutual fund units.

  • Short-Term Capital Gains (STCG):


    If you sell your mutual fund units within one year of investment, the gains are classified as short-term.

    • STCG is taxed as per your income tax slab, unless the securities fall under specific notified categories—where gains are taxed at a flat 20%.

  • Long-Term Capital Gains (LTCG):


    If you sell the units after one year, the gains are considered long-term.

    • LTCG is taxed at a flat rate of 12.5%, and no indexation benefit is available.
    • However, listed equity shares (including equity mutual funds) qualify for an exemption on gains up to Rs. 1.25 lakh per financial year.
    • Gains above this threshold are taxed at 12.5%.

What is the minimum amount you need to invest

The minimum amount required to invest in small-cap mutual funds varies depending on the fund and the investment platform. Typically, most small-cap funds allow investors to start with a Systematic Investment Plan (SIP) for as low as Rs. 500 to Rs. 1,000 per month. For lump-sum investments, the minimum amount usually starts around Rs. 5,000. Small-cap funds are a popular choice for investors seeking long-term growth and willing to accept higher risks due to market volatility. By starting with smaller amounts, investors can gradually build their portfolio while benefiting from the growth potential of small-cap companies.

How do I know if small cap funds are suited to me?

Small-cap funds can offer high growth potential but come with greater risk. To know if they are suitable for you, consider the following factors:

  • Risk tolerance: You are comfortable with market volatility and willing to accept higher risks for potentially greater rewards.
  • Investment horizon: You can stay invested for at least 7-10 years to ride out market fluctuations.
  • Financial goals: You are seeking long-term capital appreciation rather than immediate returns.
  • Diversified portfolio: You already have a balanced portfolio and want to add higher-growth opportunities.
  • Understanding market dynamics: You have a fair understanding of market trends and the risks of investing in smaller companies.

Is a Small-Cap Fund investment better than a Large-Cap Fund?

Investing in small-cap funds versus large-cap funds presents different risk-reward profiles that cater to various investor preferences. Small-cap funds focus on companies with a market capitalisation of less than Rs. 5,000 crore, often offering higher growth potential. These funds are suitable for investors looking for substantial capital appreciation over the long term. Historically, small-cap stocks have outperformed large-cap stocks, especially during bull markets, due to their agility and room for expansion.

However, small-cap funds come with higher volatility and risk. The price fluctuations of smaller companies can be significant, and these funds may be more susceptible to market downturns. In contrast, large-cap funds, which invest in well-established companies ranked among the top 100 by market capitalisation, provide more stability and lower risk. These funds tend to have more predictable earnings and are generally more resilient during market fluctuations, making them suitable for conservative investors or those seeking steady returns.

Ultimately, the decision between small-cap and large-cap funds should align with your investment goals, risk tolerance, and time horizon. A diversified approach that includes both small-cap and large-cap investments can balance potential high returns with stability, thereby optimising your portfolio's overall performance.

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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.

 


How can you invest in small-cap funds through the Bajaj Broking website?

Investing in small-cap funds through the Bajaj Broking website is straightforward and can be done in a few simple steps:

  • Create an account: Start by visiting the Bajaj Broking website or app. If you’re a new user, register by providing your basic details and completing the KYC (Know Your Customer) process.
  • Choose mutual funds: Once registered, navigate to the mutual funds section and select ‘Small-Cap Funds’ from the various categories available. Browse through the list of small-cap funds offered.
  • Research funds: Take the time to analyse the performance, risk levels, and objectives of different small-cap funds. Look for funds that align with your investment goals.
  • Select the fund: After thorough research, choose the specific small-cap fund you wish to invest in.
  • Decide on investment amount: Determine whether you want to make a lump-sum investment or set up a Systematic Investment Plan (SIP) with monthly contributions. Enter your desired investment amount.
  • Complete payment: Follow the prompts to complete your investment. You can choose various payment options, including online banking or debit/credit cards.
  •     Track your investment: After investing, regularly monitor the fund's performance through your Bajaj Broking account, allowing you to make informed decisions about your portfolio.


Key takeaways

  • Small cap mutual funds must invest a minimum of 65% of their assets in equity and equity-related instruments of companies ranked 251st and below by market capitalisation — typically those with a market cap below Rs. 5,000 crore.
  • These funds are best suited for investors with a long-term investment horizon of at least seven to ten years, as short-term volatility can be significant.
  • Long-term capital gains above Rs. 1.25 lakh are taxed at 12.5%, with no indexation benefit available.

  • The risk-reward profile of small cap funds is higher than large cap or mid cap funds, making them suitable for investors with aggressive growth goals and a high tolerance for market fluctuations.



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. Begin securing a prosperous future by investing in mutual funds on Bajaj Broking.



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Frequently asked questions

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.

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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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.

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