What are small cap funds, its features, and benefits?

For investors seeking a high-growth potential, venturing into the world of small cap mutual funds can be an exciting option. However, understanding the unique features, benefits, and risks of small cap funds is crucial for informed decision-making.

So, let us try to understand and navigate the exciting world of small-cap funds.

• Table of contents

• What are small cap mutual funds
• How Do Small Cap Mutual Funds Work?
• Features of small cap mutual funds
• Benefits of small cap fund
• Taxability of Small Cap Mutual Funds
• Why consider small cap funds?
• Important considerations
• Risks associated with small-cap funds
• Small cap funds - How to manage risk
• Suitable Small-Cap Allocation for Investors
• Who Should Invest in Small Cap Mutual Funds?
• How To Invest in Small-Cap Funds?

What are small cap mutual funds?

Small cap mutual funds are essentially equity funds that allocate a significant portion of their funds to stocks of small companies. The Securities and Exchange Board of India (SEBI) establishes the list of top companies and sets the norms for the investment portfolios of various types of funds. According to SEBI, small cap stocks are those that are ranked 251 and beyond based on market capitalisation. Fund managers actively seek out these small-capitalisation stocks, which have the potential to outperform benchmark indices and large cap stocks.

Investing in stocks with the potential to become significant players in the future and generate favourable returns is a key strategy for small cap fund managers. Consequently, investors in small cap funds have the opportunity to capitalise on the growth potential of smaller companies, diverging from the strategies of institutional and large-cap investors.

In bull markets, small cap funds can outperform large cap or mid cap funds, as smaller companies have the room to realise their full potential, leading to a relatively better return potential.

How do small cap mutual funds work?

Below is an outline of how small-cap mutual funds function.

Collecting investments: The fund gathers money from multiple investors.

Investing in small-cap stocks: The fund manager allocates this pooled capital to a range of small-cap companies.

Expert management: A team of professionals conducts thorough research to identify companies with strong growth potential.

Active strategy: These funds are usually actively managed, meaning fund managers frequently adjust the portfolio by buying, holding, or selling stocks in an attempt to outperform the market.

Units allocation: Investors receive fund units based on the amount they invest.

Net asset value (NAV): NAV represents the total value of the fund’s holdings divided by the number of units. It fluctuates based on the prices of the stocks in the portfolio.

Capital appreciation: If the stock prices increase, NAV rises, leading to potential growth in investment value.

Features of small cap mutual funds:

SEBI mandate: Small cap funds must invest more than 65% of the fund corpus in small cap stocks

High growth potential: Small cap companies, driven by innovation and adaptability, offer the potential for explosive growth, outperforming larger, established firms in favourable market conditions.

Higher volatility: As emerging entities, small cap companies are more susceptible to market fluctuations, leading to potentially higher upswings and downswings in their stock prices.

Diversification: Investing in a small cap fund offers exposure to a diversified basket of potential young companies, spreading your risk and potentially boosting your portfolio's return potential.

Long-term focus: Due to their inherent volatility, small cap funds are suited for investors with an extended investment horizon (ideally 5 years or more) who can ride out market fluctuations and reap the potential rewards of long-term growth.

Active Management: Small cap funds rely heavily on the skill and expertise of fund managers who identify and invest in the good potential small cap companies. This requires careful research and selection.

Benefits of small cap fund:

Returns: Over the long term, small cap funds have historically delivered higher returns compared to their large cap counterparts, making them suitable for growth-oriented investors.

Beating inflation: The high growth potential of small cap companies can potentially outpace inflation, preserving your purchasing power over the long term.

Early access to emerging stars: Investing in small cap funds allows you to gain early exposure to potentially high-growth companies before they become established giants, maximising the return potential.

Portfolio diversification: Adding small-cap funds to your portfolio diversifies your overall holdings. While large caps can provide relative stability, small caps allow you to harness the growth potential of businesses poised to take off.

Taxability of small cap mutual funds

Small-cap mutual funds, like other equity mutual funds, are subject to capital gains tax in India. Below is an overview of how these taxes apply.

When you sell your mutual fund units at a profit, the tax treatment depends on how long you held them:

Short-term capital gains (STCG): If units are sold within 12 months, the gain is considered short-term and taxed at 20% along with applicable cess and surcharge.

Long-term capital gains (LTCG): If units are held for more than 12 months, the gain is treated as long-term and taxed at 12.5% on gains exceeding Rs. 1.25 lakh in a financial year. No indexation benefits are available for LTCG on equity funds.

How tax is calculated: The gain is determined by subtracting the purchase price from the selling price of units.

Why consider small cap funds?

Potential for relatively better returns

Small cap stocks tend to offer a relatively better return potential than large caps over long periods of 10-15 years. This is because smaller companies have more scope for revenue and profit growth as their operations scale up. Successful small caps that carve a niche for themselves can potentially deliver good returns in the long-term. Small cap funds give exposure to such growth stories at an early stage and the potential upside makes them a suitable investment option.

Diversification benefits

Including small cap mutual funds in your portfolio may provide diversification across various sectors. Large caps tend to be dominated by a few heavyweight sectors like finance, oil & gas, FMCG etc. Small caps add exposure to new age sectors like technology, engineering, EVs etc. Thus, proper diversification through small cap funds can enhance overall risk-adjusted returns.

Opportunity for building wealth

Small cap stocks that are able to survive cyclical downturns through prudent management tend to grow exponentially over long periods of 10-15 years. Even small investments in such rising small caps can translate into sizable wealth over the years through the power of compounding returns. Regular investing in small cap funds through SIPs facilitates rupee cost averaging and eliminates timing risks. It allows accumulating more units during periods of market volatility. Successful small cap picks held for long have the potential to become multi-baggers and create substantial wealth over a long horizon.

Suited for long term investors

Success in small cap investing depends on patience and investing with a long-term. It takes time for smaller companies to establish themselves, stabilise operations, and deliver profitable growth. Short term performance can be volatile as these stocks are also impacted by company-specific events. However, over long periods of economic and business cycles, consistent small cap performers tend to reward investors. Therefore, small cap funds can be suitable for investors with a long-term investment horizon who can ride out interim volatility and focus on the bigger picture. Monthly SIPs can be preferable over lumpsum investments to withstand market volatility.

Important considerations:

High risk: Remember, small-cap investments come with inherent risks due to their volatility and uncertainty. Be prepared for potentially significant short-term fluctuations in your investment value.

Long-term investment: Do not invest in small cap funds with a short-term outlook. These funds are suited for those who can ride out market volatility and focus on long-term growth potential.

Active management: Choose a small cap fund with a proven track record and a skilled fund manager who demonstrates expertise in identifying and investing in potential and exciting small cap companies.

Capital growth: Invest in small cap funds for potentially significant capital growth in the long run. These funds focus on growth opportunities by diversifying and balancing your portfolio.

Risks associated with small-cap funds

Small-cap companies are younger and smaller in size and operations compared to large-cap companies. This makes their business models and operations more vulnerable to setbacks and fluctuations in the economy. Some key risks to consider as a small-cap fund investor are as follows:

• Volatility risk: Share prices of small companies seesaw more sharply with market movements compared to large-cap stocks or mid-cap stocks. Small-cap funds tend to have higher volatility.
• Liquidity risk: Smaller companies have lower trading volumes for their shares. This might make it difficult to sell your holdings quickly in times of downturns.
• Business model risk: Smaller firms have shorter operating histories. Their business models are often unproven over different economic cycles.
• Financial risk: Small companies have lower access to capital. Any adverse business/financial setback can impact their operations and survival, thus impacting the performance of small cap funds that invest in them.
• Concentration risk: Small-cap funds may take high exposure to specific sectors/stocks. This can lead to higher concentration risk in the portfolio.
• Lack of coverage: Smaller companies tend to attract lower analyst/media coverage and availability of information is lower.

Small cap funds - How to manage risk

Here are some practical tips for investors to manage risks in small-cap fund investments:

• Moderate allocation: Limit your allocation to small-cap funds to 10-20% of your overall portfolio. This can ensure that high-risk exposure is capped at prudent levels. Avoid taking overly aggressive bets on small-cap funds.
• Diversify across funds/stocks: Invest in 2-3 small-cap funds rather than just one. This ensures your portfolio is diversified across fund managers and investment approaches. Also, choose actively managed diversified small-cap funds over sectoral/concentrated funds.
• Long investment horizon: Small-cap investments require a patient, long-term outlook of at least 5-7 years. Their volatility tends to even out over longer time frames. Avoid knee-jerk reactions to short-term fluctuations.
• Systematic Investment Plans (SIPs): Prefer systematic SIP investments over lumpsum investments in small-cap funds. This averages out your purchase costs and reduces timing risks. Keep SIPs running even during market downturns.
• Avoid redemptions in down markets: Don't rush to redeem your small-cap investments during periods of sharp correction. Give time for recovery as downturns are temporary but loss realisation is permanent. .
• Monitor performance: Keep a close watch on your small-cap funds' performance across market cycles and peer comparisons. Review holdings periodically. Replace underperforming funds after giving sufficient time to recover.
• Risk profiling: Those with lower risk appetite and near-term goals should limit exposure to small-cap funds. These are more suited for investors with a very high risk tolerance and long investment horizons. Small cap fund techniques for investors like maintaining balanced allocation across large-cap, mid-cap and small-cap assets is crucial for effective portfolio management.

Important tips for small cap fund investors are to avoid overexposure and maintain long investment horizons to ride out volatility. Prudent risk management techniques for small cap fund investors involve diversification across stocks and funds, systematic investments, portfolio rebalancing and loss capping through stop-losses.

Suitable small-cap allocation for investors

The ideal allocation to small-cap funds varies based on an investor's risk profile, investment horizon, and portfolio size:

• Conservative Investors: Up to 5% of portfolio
• Moderate Investors: 5-10% of portfolio
• Aggressive Investors: 10-15% of portfolio

Higher allocation limits of 15-20% should only be considered by investors with the highest risk appetite, investment experience and ability to withstand extreme volatility. Those new to small-cap funds should begin with a smaller allocation.

Who should invest in small cap mutual funds?

Small-cap mutual funds can be a valuable addition to an investment portfolio, but they may not be suitable for everyone. Below is an overview of investors who may benefit from them and those who might want to reconsider.

High-risk tolerance: Small-cap funds experience significant price fluctuations. Investors comfortable with market volatility and potential short-term losses may find them suitable.

Long-term investment approach: These funds align better with long-term financial goals (7-10 years or more), allowing companies time to grow and recover from market downturns.

Focus on growth: Investors aiming for long-term wealth creation and willing to accept higher risk for potential returns may consider these funds.

Diversified portfolio: Including small-cap funds alongside large-cap funds, debt funds, and gold can help manage overall investment risk.

How to invest in small-cap funds?

Steps to invest in small-cap mutual funds:

Research and select a fund: Assess the manager’s experience and track record in handling small-cap investments. Compare expense ratios of different funds to keep investment costs manageable. Understand sector allocations and company types included in the fund.

Choose an investment method:

Lumpsum: Investing a single amount can be beneficial during market lows but carries timing risks.

Systematic investment plan (SIP): Regular investments (monthly or quarterly) help average out costs and manage market fluctuations.

Select an investment platform:

Direct plan: Investing directly via the mutual fund company’s website usually incurs lower costs.

Distributor: A financial advisor or distributor can provide guidance but may charge commissions.

Online platforms: Digital platforms offer convenience and multiple fund options.

Complete KYC (Know Your Customer): Investors must provide identity proof, address proof, and PAN details. The process can be completed online or through a KYC registration agency (KRA).

Make the investment: Direct or platform-based investments can be completed via net banking, debit card, or UPI. Investing through a distributor requires submitting an application form along with supporting documents and payment.

Conclusion

Small cap funds offer a thrilling entry point to the world of potentially exciting returns. However, their inherent risks and volatility demand careful consideration and thorough research. By understanding features and benefits of small cap funds, assessing your risk tolerance, and practising smart investment strategies, you can harness the power of small cap mutual funds to unlock a rewarding investment journey. Remember, always invest with a long-term perspective and a sound approach to risk management.

FAQs:

Are small-cap funds suitable for everyone?

No, small cap funds are not for everyone. Their high volatility and risk profile make them suitable for investors with a high-risk tolerance and a long-term investment horizon.

How much should I invest in small cap funds?

The amount you invest in small-cap funds should be based on your individual risk tolerance and overall portfolio allocation. It's generally advisable to limit your exposure to small cap funds to a smaller percentage of your portfolio.

Should I invest in a single small cap fund or diversify across multiple funds?

Diversifying across multiple small cap funds with different investment styles and industry focuses can help mitigate risk and potentially enhance your long term returns

How does one select a good small cap mutual fund for investment?

There are a few factors to consider while selecting a small cap mutual fund - the performance track record of 3-5 years, consistency in delivering returns, fund manager experience in small cap investing, portfolio diversification, expense ratio and turnover ratio.

What is the minimum investment amount required for small cap funds?

Most small cap funds have a minimum investment amount of Rs. 500 to Rs. 1,000 for one-time investments. For SIP investments the minimum amount is generally Rs. 500 per month.

Should I stop my small-cap SIPs during market falls?

Avoid stopping your SIPs during market falls. In fact, market corrections provide an opportunity to accumulate more small-cap fund units at lower prices through SIPs. Stay invested

How often should I review my small-cap funds?

Review your small-cap funds at least every six months. Assess portfolio concentration, performance across cycles and peer comparisons. Allow underperforming funds 1-2 years to recover before replacement.

Are small-cap funds only suitable for aggressive investors?

No, moderate investors can also consider allocating a small (5-10%) part of their portfolio to small-caps as part of a diversified strategy and a long-term investment outlook. Conservative investors who want to take equity exposure as well may restrict to less than 5% allocation.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.