What Are Small Cap Mutual Funds & How to Invest?

Investors are always on the lookout for new opportunities and high returns in the stock market. Small-cap companies can offer just that, but investing in them can be tricky without proper research. Small-cap mutual funds offer a solution by allowing you to invest in the small-cap growth story in a disciplined manner with expert guidance.

In this article, we will learn key aspects of small-cap mutual funds to help you evaluate if they are suitable for your investment objectives.

What are small-cap mutual funds?

Small-cap mutual funds invest in small companies that have a market cap of Rs 100 crore to Rs 2,000 crore and are in the early growth stage. Fund managers aim to identify small companies with strong potential to grow into large companies over time. The goal of these funds is to generate better returns by investing in promising small companies that other yet to be noticed or overlooked.

Key features of small-cap mutual funds

Here are some salient features of small-cap mutual funds:

1. As per SEBI rules, at least 65% of the fund corpus should be invested in small-cap stocks
2. Tend to be concentrated funds, not as diversified as large/multi-cap funds  
3. Have the potential to deliver higher returns than large caps due to higher growth runways
4. Exhibit high volatility and are prone to huge fluctuations with market cycles
5. Ideal investment tenure is 5 years or more to realise the full growth potential  

In addition to these characteristics, small-cap funds have flexible investment approaches. Based on market conditions, fund managers can switch between growth and value investing styles along with market capitalisation categorisations within small caps for optimised returns.

Who should invest in small-cap mutual funds?

While small-cap funds can be rewarding in the long run, they may only be suitable for some kinds of investors. Ideal investors for this category possess the following attributes:

1. Have a high-risk tolerance ability
2. Are focused on long-term wealth creation rather than short-term gains
3. Willing to endure volatility during different market cycles
4. Want to add an aggressive fund to their portfolio for diversification 

Small-cap mutual funds are risky and may need to be more stable. Large-cap funds are safer, more secure, and better for investors who want steady returns or are nearing retirement.

Things to consider before investing 

While the high growth potential of small caps is alluring, don’t let it cloud your judgment. As a prudent investor, keep these aspects in mind:

1. Investment Objective- Your goal timeframe should ideally be 7+ years to harness the power of small caps fully. 

2. Risk Appetite – Determine if your risk tolerance aligns with the volatility of small-cap funds

3. Asset Allocation – Experts suggest allocating just 10-20% of your mutual fund portfolio to this category

4. Past Performance – Opt for funds with long-term outperformance vs standard and equivalents 

5. Portfolio Holdings- Prefer funds with concentrated bets rather than pseudo diversification.

6. Costs – Choose funds with low expense ratios to maximise returns

Are small-cap funds better than large-cap funds?

There is no clear winner in the small vs large cap funds debate. Both categories have distinct risk-return characteristics that make them suitable for different investor profiles and goals.  

However, in general, small caps have demonstrated higher growth trajectories and outperformance across market cycles. 

Key benefits of investing in small-cap mutual funds

Here are some of the major advantages of parking a part of your mutual fund investments in small-cap funds:

1. High growth potential

Small-cap companies are in nascent stages with robust future expansion runways. Investing in them early on can deliver superior returns over the long term.

2. Undervalued gems 

Inefficient small-cap segment offers opportunities to invest in undiscovered, undervalued stocks with strong fundamentals.  

3. Diversification 

Small caps provide diversity to the portfolio in terms of business models, sectors and market capitalisation.

4. Wealth creation

Potential to generate higher inflation-beating returns to meet long-term life goals.

5. Liquidity events  

Listing gains, acquisitions, and buybacks in small caps can trigger unexpected gains.

Investing in small-cap mutual funds is a smart move for long-term wealth accumulation by tapping into the high growth potential of small companies.

Key risks of investing in small-cap mutual funds 

While small caps come with mouth-watering return potential, they also carry higher risks that should be evaluated upfront. Some key risks include:

1. Volatility: Small caps witness wild swings with market movements on account of lower trading volumes and investor interest.

2. Limited track record: New companies need more operating history and financial data to analyse and predict prospects. 

3. Lack of analyst coverage: Lower research coverage on less-tracked small companies leads to information asymmetry for investors.  

4. Low liquidity: Thinly traded small-cap stocks suffer from weak liquidity that can exaggerate price movements.

5. Corporate governance: Small companies tend to need stronger internal controls and compliance standards.

6. Business failures: Unable to survive competitive pressures, many small companies go bankrupt each year.

Therefore, be careful when investing in small company funds. Don’t focus only on past performance; also analyse risks and be disciplined during market downturns. Small-cap rewards require patience and persistence.

Conclusion

Small-cap mutual funds offer high potential returns but come with higher risks due to their volatility. Diversify your portfolio with a moderate allocation and invest for at least five years. Choose funds wisely and stay committed during tough times to benefit from the long-term compounding effect of small-cap investments.

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