What are Small Cap Mutual Funds?

Stocks that we invest in are categorised based on market capitalization. Market capitalization or market cap is a measure of a company’s value. Based on that, stocks are labelled as large-caps, mid-caps and small-caps. All three categories of stocks vary in scope of returns and risk involved.

Equity mutual funds that invest predominantly in small-cap stocks are known as small-cap funds. In this article, we will explore the features, benefits and factors affecting small-cap mutual funds.

What is Small Cap Fund?

As the name suggests, small-cap funds invest majorly in small-cap stocks. According to SEBI, barring the top 250 companies as per market capitalization, all are small-cap companies. Therefore, small-cap stocks are ranked 251st and beyond on the stock exchange. They generally have a market cap of less than Rs 5,000 crore. 

These companies are small in size and have significant growth potential. And when they grow, their share prices also surge sharply. Some small-cap companies can double or triple in value over a short period. However, it is important to understand that they are also high-risk investments. They tend to see sharp fluctuations when the market is volatile. Therefore, small-cap mutual funds are more suitable for aggressive investors who can take higher risks.

Key Features of Small Cap Funds

Here are some key characteristics of small-cap funds:

• Small-cap funds allocate at least 65% of investment to small-cap stocks.
• They can offer higher returns than other equity funds as the companies they invest in have a high scope of growth.
• These funds carry a high risk. They perform very well during a bullish market but when the tide turns and the market falls, they are mostly the worst hit.
• Small-cap funds do well over the long term as these companies need time to grow.

Benefits Of Investing In Small Cap Funds

Investing in the best small-cap funds has many advantages. Take a look:

High Returns: Small-cap funds invest in small-cap companies with significant growth and expansion potential. If these companies expand, it can lead to substantial returns for investors.

Diversification Benefits: Small-cap funds can diversify a portfolio by taking exposure to companies with high growth potential. This diversification can enhance portfolio performance and reduce dependency on large-cap and mid-cap stocks.

Undervalued Assets: Small-cap stocks are undervalued because they are less discovered and not on the radar of large investors. This also means that they have huge room for growth. Small-cap funds, therefore, can be a great investment if you can stomach higher risks. 

Risks of Investing In Small Cap Mutual Funds

Now that we have understood the advantages of a small-cap fund, let's also look at the risks involved:

Highly Volatile: A small-cap fund is highly volatile, especially in the short to medium term. It can fluctuate wildly during stock market swings, resulting in huge losses. This makes it riskier than a large-cap fund. You should invest in small-cap funds to meet your long-term investment objectives.

Liquidity Risk: Institutional participation in small-cap stocks is low, and even retail investors don't invest extensively in them. This exposes small-cap funds to liquidity risks.

Who Should Invest in a Small Cap Fund?

As an investor, if you are willing to take more risks, then you should consider small-cap equity funds. These funds can offer stellar returns when the markets are doing well. However, when markets turn bearish, they are among the worst impacted and may take a long time to recover. You should invest in a small-cap fund to meet your long-term investment objectives. It is ideal to allocate some portion of your portfolio to small-cap stocks to not miss out on capital appreciation. 

Factors To Consider Before Investing in Small Cap Funds

Since small-cap funds carry a higher risk than large-cap and mid-cap funds, it’s important to consider these factors before investing in them.

Investment Risk: Undoubtedly, even the best-performing small-cap funds carry high risk, even if they give solid returns. Therefore, when picking a small-cap fund, choose the one with a history of performing better than the benchmark and other small-cap funds to ensure a good return on your investment.

Investment Returns: You can look to allocate a portion of your portfolio to the small-cap fund despite higher risks because not investing in it could mean missing out on significant potential returns.

Cost of Investment: Small-cap equity funds incur a cost known as the fund's expense ratio. While selecting a small-cap fund, consider your net profit after such expenses. According to SEBI guidelines, the expense ratio for these funds is limited to 2.50%.

Past Performance: While selecting a small-cap fund, look at the past performance of at least 4-5 years. A good performance indicates effective stock selection by the fund manager and suggests the scheme can navigate difficult market conditions successfully.

Investment Objective: Even the top-performing small-cap mutual funds can experience significant declines when the market conditions are poor. Therefore, to get the most gains from your investment, park your funds for long-term goals like children’s education, buying a home or retirement plan. 

Taxation Rules of Small Cap Mutual Funds

Investors have to pay taxes on gains made from selling small-cap mutual funds. The tax is called capital gains tax and depends on your holding period.

Short-term Capital Gains Tax or STCG

If you invested in a small-cap fund for less than 12 months, gains earned are taxed at a flat rate of 20%.

Long-Term Capital Gains Tax or LTCG

If you invested in a small-cap fund for over 12 months, gains up to ₹1.25 lakh are exempt from taxes. Any gain above this amount is taxable at 12.5%.

How To Invest In Small Cap Mutual Funds

Follow these steps to start investing in small-cap funds:

• Open the INDmoney app and log in with your credentials.
• Navigate to the "Mutual Funds" section within the app.
• Use the filter options to select "Small-Cap Funds" to view the available options.
• Decide whether to make a lump sum investment or set up a Systematic Investment Plan (SIP) for regular contributions.
• Enter your desired investment amount and confirm the transaction.