Small Cap Mutual Funds

In October 2017, SEBI issued a circular ‘Categorization and Rationalization of Mutual Fund Schemes’ to categorise the market capitalisation of stocks . This circular defined companies in 3 categories - Large Cap, Mid Cap and Small Cap. These companies are ranked on the basis of their market capitalization. 

Large Cap includes companies that rank 1st to 100th in stock exchange. Mid Cap includes companies that rank 100th to 250th and Small Cap represent companies that rank 251st and beyond. This was done to ensure uniformity in the market. 

Further, SEBI also mandated for AMC’s to only include one scheme in a particular category. This process made certain that AMCs do not have plans in multiple schemes coinciding with different categories of companies. 

Small-cap, mid-cap, and large-cap companies differ primarily in their market capitalization and growth stages. Large-cap companies are well-established businesses with a long history in the industry. They are known for their stability and lower volatility, making them a less risky investment choice. 5

Small-cap companies, on the other hand, are usually early-stage or emerging businesses with significant growth potential. They are more volatile and come with higher risks since their stock prices can fluctuate dramatically in a short period. Despite the higher risk, small-caps can yield substantial returns for investors often surpassing the volatility.

Mid-cap companies represent a balance between large-cap and small-cap firms. They offer a mix of growth potential and risk, being less stable than large-caps but also less risky than small-caps. These companies are often in their expansion phase and present moderate growth opportunities. 

The expense ratios of Small Cap Mutual Funds tend to be higher than those of other types of mutual funds for several reasons:

1. Active Management: Small-cap funds are usually actively managed due to the need for thorough research. Active management involves higher costs related to research, analysis, and trading.
2. Market Volatility: Small-cap stocks are generally more volatile than large-cap stocks, leading to increased trading activity as fund managers may frequently adjust their portfolios in response to market changes. This higher turnover can elevate transaction costs.
3. Limited Economies of Scale: Many small-cap funds have lower assets under management (AUM) compared to larger funds, which means that fixed costs (like management fees) are spread over fewer assets, resulting in a higher expense ratio.
4. Regulatory Compliance: Meeting regulatory requirements and maintaining transparency also incurs costs that contribute to higher expense ratios for small-cap funds.

Investors with a long-term investment horizon should pick small-cap funds. Ideally, investors should have a holding period of 5-10 years to make the most of their investment.

If you redeem your mutual fund too early, the mutual fund house you’ve invested with, might charge you an exit load. Exit load is a small fee charged by AMCs if an investor withdraws funds within a specified period (typically 1 year). 

This is done to discourage early withdrawals and to ensure that investors stay committed for a reasonable period. Moreover, small-cap funds reap its true benefits in the long-term; since the companies in this category need time to grow and deliver returns.

When you’re deciding if you want to invest directly with an AMC or a platform, you must weigh the pros and cons of both choices. When investing with an AMC for example; you invest directly with the mutual fund house, but then the challenge comes when you have to manage multiple AMC accounts on a monthly basis.

INDmoney for example offers 1600+ direct mutual funds in different categories on one app. So if you want to invest across different funds you don’t have to create accounts at different places. You just need to create your account once on INDmoney and you can invest and manage multiple funds from the app.

Further, when you invest through AMC's, what's missing is analysis on your investments. The fact sheet of a fund that an AMC offers only shows you details of the fund; but the real picture of how your investments are performing in comparison to other funds is missing.

Any other platform would offer you insights on your investments. On INDmoney, you get a portfolio scan that tells you what funds in your portfolio are underperforming, what the average investment in your age group, what you top holdings are, which sector dominates your portfolio and more.

The choice however to invest with an AMC or a platform depends on your priorities. If you don’t mind managing funds across different AMCs and draw analysis on your own; AMC is the way to go. On the other hand if you’re someone who prefers everything in one place, using a platform would be the ideal choice.

When you redeem your mutual funds, it typically takes 2–3 working days for the funds to be credited to your bank account. However, the exact timeline may vary depending on the AMC (Asset Management Company) you’ve invested with.

Here’s how the redemption process works: When you sell your mutual fund units, the AMC buys them back at the current day’s NAV (Net Asset Value). The NAV is calculated at the end of the trading day, and the redemption amount is based on this value.

It’s essential to understand this process so you can plan your redemptions accordingly, especially if you need the funds within a specific timeframe.

Exit load is a charge levied on investors for premature redemption of funds. Every AMC issues a fact sheet or scheme information document that clearly states, if an investor withdraws mutual funds within a specified period (usually 1 year), they will be levied an exit load. The exit load varies for different funds, but typically ranges from 0 to 1%. This is charged on the current value of your investment. 

Let’s understand this with an example, say you invested ₹100,000. The NAV when you purchased the mutual fund was ₹10. Total units bought by you were: 100,000/10 = 10,000.

Say you held the investment for 9 months and decided to redeem. The NAV on the date of redemption is ₹12. The value of your current investment would be: ₹10,000* 12 = 1,20,000.

The exit load specified by the fund is 1%; so you’ll have to pay a total of ₹1200 (1,20,000 * 1%)  as exit load to the AMC.

There are primarily two disadvantages of a small cap mutual fund:

1. Highly Volatile: A small-cap fund is highly volatile, especially in the short to medium term. Its prices fluctuate wildly during stock market swings, resulting in huge losses. This makes it riskier than a large-cap fund. 

2. Liquidity Risk: Small cap funds generally have lower trading volumes in comparison to large-cap funds. This means every time a fund manager buys or sells stocks, the share prices see sharp fluctuations leading to liquidity risk. Meaning it’s difficult to convert investments into cash without incurring huge losses.

Long-term investing typically means a horizon of more than 7 to 10 years. To maximize the benefits of your investments and unlock their full potential, it’s essential to hold small-cap mutual funds for a significantly extended period. A long-term approach allows your investment to weather market volatility, benefit from compounding, and grow to its true value.

Despite your small-cap allocation, it’s generally advised to rebalance your portfolio every 6 to 12 months. The asset allocation across funds is highly subjective - it’s based on your goals, risk tolerance, and investment horizon. 

For example, if you’re a retired person you’d like to invest in funds that are less volatile to secure your investments. On the other hand, if you’re a younger investor you may want to take on higher risk for better rewards. When it comes to small-cap funds, they see sharper price swings compared to large-cap funds. 

This means your portfolio can move from its intended allocation faster, which also means you’ll need to monitor your funds closely. Say a market rally causes your small-cap allocation to grow significantly beyond your initial allocation, you may be overexposed to risk. 

Rebalancing ensures you remain aligned with your risk tolerance. For example - If small-cap funds make up 10% of your portfolio and a market rally pushes them to 30%, you might consider rebalancing to avoid being overexposed. Conversely, if their value tanks, rebalancing can help you buy low.

The percentage of your portfolio allocated to small-cap mutual funds depends on several factors, primarily your risk appetite, investment goals, and long-term vision from that fund. It also depends on what category of investor you really are. If you’re a conservative investor you’d more likely be inclined to invest in a fund that is less volatile and safe. Conversely, If you’re an aggressive investor, you are more likely to invest in a fund that is volatile but also promises higher returns than other funds.

Small-cap funds are known for their high growth potential, but they also come with significant volatility. If you’re a conservative investor, you might allocate a smaller portion, say 5-10%, to small-cap funds to minimize risk. If you’re an aggressive investor, you might go higher, perhaps 20-30%, aiming for higher returns while accepting the associated risks.

Short-term goals (less than 3-5 years) may not align well with small-cap funds due to their unpredictable performance over short periods. For long-term goals, small-cap funds can be a valuable addition, as their volatility smooths out over time and they capitalize on growth opportunities. To put in simple words, assess your investor persona, goals and risk tolerance and decide how you want to allocate your funds.

There isn’t a one-size-fits-all timeline for exiting a small-cap mutual fund investment, as it depends on your personal goals and market conditions. However, here are some key scenarios when you might consider redeeming your investment:

1. If your small-cap mutual fund consistently underperforms its benchmark and shows no signs of recovery, it may be time to exit.

2. If the fund manager changes and you’re not confident in the new manager’s expertise or track record.

3. If the investment has fulfilled your financial goals. For example, you’ve reached the target amount you invested in this fund for. It's maybe a good time to redeem and enjoy the returns.