Small-cap Funds: Features, Benefits, and Factors to Consider

Small cap mutual fund puts fund money into company stocks that have a market capitalization below Rs. 5000 crores. Notably, small cap is equity mutual fund’s subcategory and their performance depends largely on market movements. According to SEBI’s classification, mutual funds ranked from 251 onwards will be categorized as small-cap funds. These funds have to park 85% of their money corpus into small-cap stocks. These stocks are known to possess high growth potential and can generate high returns in the long term. 

On that note, let’s discuss the features and benefits of small-cap mutual funds in brief. 

Top Traits of Small Cap Funds

These are the major features of small-cap mutual funds –

Asset allocation: Small-cap funds are mandated to put 65% of their corpus in small-cap stocks, i.e.,  shares of companies that rank below 250. As a result, these funds have a high growth potential as small companies tend to have more scope to grow and can help investors generate high returns. 

• Volatile: Since small-cap mutual funds park the majority of the corpus into small companies, the funds are subject to market risks and considered highly volatility. This means the bear market trend triggers huge losses for this fund, while the bull market trend generates high returns.
• Risk-reward ratio: Typically, small-cap mutual funds are considered to be riskier than large-cap funds and mid-cap funds over the mid and short term. This is because small companies are still finding their ground and are considered to be  However, these funds are known to generate substantial returns on investments that often outperform other equity funds in the long run.
• Tax: The gains on small-cap funds are subjected to taxation as per their holding period and taxed as short-term or long-term capital gains. To elaborate, small-cap fund units that were held for less than a year are subject to short-term capital gains at the rate of 15%, regardless of the earnings. On the other hand, gains on small-cap funds units held for more than a year are subject to long-term capital gain tax. Notably, gains above Rs. 1 lakh attract a long-term capital gain tax of 10%. However, if the total capital gain is less than Rs. 1 lakh in a given fiscal year, it is usually tax-free.
• NAV: Since small-cap funds are subject to market volatility and exposes investor’s portfolio to high risks, the value of the assets involved tend to fluctuate as well. As a result the NAV of small-cap funds also surged drastically during the bear market phase.

Individuals can add small-cap funds into their investment portfolio to diversify the same and generate above-inflation returns. While these funds help generate high returns and grow portfolios, individuals must note a few things before investing in this fund and know more than what is index funds and other index funds that mimic their performance to generate returns.

Is Small Cap Mutual Fund Suited for You?

Small-cap funds bear higher risks than most other equity funds. This is because of the perceived market standing of the small companies and their weak financial stability under difficult situations. As a result, many believe that small-cap companies will be unable to withstand market fluctuations, especially in a bear market, and may suffer heavy losses. 

On the other hand, during a bullish market trend, small-cap funds can help generate high returns on investment and even have the potential to outperform mid and large-cap funds’ earnings potential. 

However, the answer to the question of whether the fund is suitable for you is subjective and depends on several factors. To begin with, individuals need to weigh in the following things before investing in mutual funds –

Investment goal: Based on one individual’s investment goal, individuals should consider whether a type of investment fund is suitable for them or not. For example, individual A can be planning to build a corpus for buying a house, whereas, individual B may plan on building a corpus for buying a car. On the other hand, individual C is planning to save up a retirement corpus through investment. These distinct goals need different investment approaches and allocation of assets across different types of funds. Hence, based on one’s investment goals they should choose a suitable fund to invest in. 

Risk-taking capacity: Individuals must factor in their risk-taking capacity before putting money into any fund, including a small-cap mutual fund. Typically, individuals who can stomach high market risks and can recover from them can invest in this volatile investment option. Individuals with little to no financial liability or major responsibilities can also consider small-cap funds.

Investment horizon: Individuals should also weigh the time horizon for their investment before picking any fund to park money. For instance, individuals with short-term goals and a planned investment horizon of 1-2 years may benefit by investing in short-term investment options to generate high returns. Since small-cap funds have a high-risk reward quotient, they can generate high returns but they are also prone to high risks. However, individuals can consider this investment option for the long term as such an investment horizon to spread out the risk and generate high inflation-adjusted returns over time. 

Advantages of Small cap Mutual Funds

These are some of the most common benefits of small-cap mutual funds –

• Growth potential: Typically, small-cap firms follow an aggressive expansion strategy to achieve growth and expansion. This aspect makes the fund a highly lucrative option to grow one’s investment portfolio and generate high earnings in the long term.
• Diversification: In case one’s portfolio is not yielding returns on investment as per expectations, one can invest money into small-cap funds. A smart allocation of corpus across small, mid, and large-cap funds can help investors generate better returns and balance risks better.

These aspects allow individuals to build a robust corpus to beat inflation and meet financial goals with ease. Additionally, it helps individuals to diversify investment portfolios and balance the risk-reward impact of the same. Regardless, individuals must strategize a suitable approach to allocate resources as per investment goal and risk tolerance level to make the most of small-cap funds. They should also opt for a suitable investment route to streamline investments and reap returns accordingly.