Small-cap mutual funds are known to park money into companies that have a market capitalization of less than Rs. 5,000 crores. They are basically a subcategory of the popular equity mutual funds, and their market performance is linked to the prevailing market movements. SEBI classifies mutual funds that rank 251 or higher as categorized as small-cap funds. These mutual funds are mandated to invest 85% of their total assets in small-cap company stocks. Notably, small-cap stocks are known to possess high growth potential and are equipped to generate high returns on investment over the long term.
Features of Small Cap Mutual Funds
Here are the top features of small-cap mutual funds –
- Asset allocation: As discussed small-cap mutual funds invest a minimum of 65% of their assets in small-cap company stocks, which are essentially shares of companies ranking more than 250 based on their market capitalization. This aspect gives small-cap mutual funds the potential to yield high returns, as small companies are believed to possess more growth potential than companies that have already achieved their peak growth.
- Volatility: Small-cap mutual funds are considered to be more volatile than other mutual funds as they invest more in small companies that are not that established to cushion major losses. This means small-cap mutual funds can experience larger fluctuations in price in both bull and bear markets, making them high in both risk and reward components.
- Risk and reward: Small-cap mutual funds are riskier than all large-cap and mid-cap mutual funds in the short and medium term. This is mostly because small firms are still going through their growth phase, making them more susceptible to the market and adding to their volatility. However, small-cap mutual funds possess the potential to generate higher returns on investment over the long term.
- Taxation: Capital gains on small-cap funds are usually taxed differently as the same is based on their holding period. Short-term capital gains or STCG are subject to taxation at the rate of 15%, regardless of the investor’s actual income tax slab. On the other hand, long-term capital gains or LTCG are tax-free for a maximum of Rs. 1 lakh yearly, but any LTCG over Rs. 1 lakh is subject to taxes at 10%.
- Net Asset Value of small-cap mutual funds: Since small-cap mutual funds are volatile, the value of their underlying assets tends to fluctuate wildly. As a result, the NAV of these mutual funds can surge drastically during the bear market phases.
- Investing in small-cap mutual funds: Individuals can add small-cap mutual funds to their portfolios to diversify their overall holdings and generate inflation-adjusted returns. However, before putting money into small-cap funds, it is essential to understand all the risks involved and similarly about the index funds and other funds that closely track the performance of small-cap indices.
Who Should Invest in Small Cap Mutual Funds?
Small-cap mutual funds are riskier compared to most equity funds as they invest in smaller, relatively less established companies. These firms may have weak financial stability and are less likely to withstand severe market fluctuations. As a result, small-cap mutual funds can face higher volatility and losses in the bear market phases.
However, small-cap mutual funds have the potential to yield higher returns than most mid and large-cap funds in the bull market phases. This is because small-cap firms have more room to grow and benefit from economic growth.
However, whether or not a small-cap mutual fund is the right choice for one depends on one’s individual risk-taking capacity and ultimate investment goals. If one is comfortable with the total risks involved and has a long investment term, small-cap mutual funds can prove to be a suitable means to boost one’s returns.
Besides that individuals should keep a few factors like these in mind before investing in small-cap funds –
Risk-taking potential: Individuals must consider their risk tolerance level before parking money into any mutual fund, including a small-cap fund. Typically, individuals who can bear high market risks and can recover from their blow swiftly can invest in this volatile investment choice. In addition, individuals with little to no financial responsibility or liability can consider small-cap mutual funds.
Individuals should choose mutual funds based on their personal investment goals. For example, if a person is saving for a big house, they will need to adopt a different investment strategy than someone who is essentially saving for a car or their retirement. Different investment goals demand different asset allocations, so it’s essential to pick the right funds for their specific financial needs.
Investment horizon: Individuals must consider how long they can remain invested in the fund scheme before choosing a type of mutual fund. For example, those with short-term goals that can be achieved in say, 1-2 years, may want to park their money in short-term investment options for higher returns. Small-cap mutual funds have a high risk-reward ratio, which means they can help generate high returns but they also carry high risks which calls for prudent cushioning of the portfolio. Therefore, investors may consider small-cap mutual funds for the long term to distribute risk and generate inflation-adjusted returns over the investment period.
Once individuals have figured out their choice of small-cap mutual fund and their limitations they can plan their investment to grow their portfolio’s value. Typically, a popular small-cap fund with a robust record of healthy market performance can help individuals appreciate their wealth build a corpus, and diversify their investment portfolio at the same time. However, they should consider adding other financial products like Fixed Deposits, protection plans like term insurance, and mutual funds based on their investment profile to diversify their portfolio and ensure they continue yielding steady returns.
Small-cap mutual funds can help individuals build a reliable investment portfolio that can help them beat inflation and achieve their personal financial goals. These funds can also help them to diversify investment portfolios and balance their risk and reward quotient. However, investors are recommended to consider their investment goals and risk-taking capacity when allocating their resources to small-cap mutual funds. They should also consider choosing a suitable investment route, like SIP to maximize their earning potential.