Table of Contents
Introduction
Small-cap funds appeal to investors seeking higher potential rewards despite greater risk. Managed by professionals, these funds target small-cap companies beyond the top 250 in market capitalization. Here, we’ll discuss their key features, suitable investors, and considerations before investing. Learn how they can provide high potential returns, helping you build a strong investment strategy.
What are Small Cap Funds?
Small-cap funds are among the most aggressive mutual funds, investing in companies ranked beyond the top 250 in market capitalization. Managed by professionals, they primarily invest in stocks, offering the potential for higher returns but also carrying higher risk due to market volatility and economic fluctuations. These funds typically allocate at least 80% of their assets to small-cap companies, defined by SEBI as those ranking below the 250th position with market capitalization less than Rs. 5000 crores.
How Does This Work?
Small-cap equity funds primarily allocate at least 65% of their assets to companies beyond the top 250 in market capitalization. Preferred by investors seeking high returns and accepting higher risk, these funds require careful portfolio selection to mitigate risks. Offering significant long-term returns, they are riskier and more volatile in the short to medium term compared to other equity funds. Despite higher risk, small-cap stocks can rapidly grow in value. Investors should maintain a long-term perspective and diversify their portfolios to manage volatility.
Features and Benefits of Investing in Small Cap Funds
High Growth Potential: Small-cap funds invest in emerging companies with significant growth potential, often in the early stages of their business cycle, which can lead to rapid expansion and higher returns.
Diversification: Including these funds in your investment portfolio adds diversity, reducing the impact of market fluctuations on your overall investments.
Market Inefficiencies: Small-cap stocks are less researched and followed by analysts, providing opportunities for fund managers to identify undervalued companies and achieve better returns.
Access to Innovators: These companies are often more innovative and agile, allowing investors to benefit from new products, services, and market opportunities.
Long-Term Gains: While small-cap funds can be more volatile in the short term, they have the potential to deliver substantial long-term gains for investors with higher risk tolerance and patience.
Risks and Returns
Before investing in small-cap mutual funds, it’s important to understand both the potential benefits and drawbacks:
Risks:
Higher Volatility: Small-cap stocks tend to be more volatile due to their smaller market capitalization and lower liquidity, leading to rapid price fluctuations and increased investment risk.
Liquidity Risk: Limited liquidity in these stocks can pose challenges in executing trades at desired prices, especially during market stress.
Business Risk: Small-cap companies face elevated business risks, including competition, market cyclicality, and regulatory changes, impacting their financial performance and stock prices.
Sector Concentration: Significant investments in specific sectors heighten the risk of adverse sector developments affecting fund returns.
Market Risk: Small-cap stocks are more sensitive to broader market movements and sentiment, leading to potential losses during economic downturns or geopolitical events.
Returns:
Higher Growth Potential: These stocks offer substantial growth potential compared to large-cap stocks, benefiting from dynamic companies’ expansion.
Diversification: They offer diversification across sectors and industries, reducing the impact of individual stock volatility on overall portfolio performance.
Historical Outperformance: Historically, small-cap stocks have outperformed large-cap stocks, driven by their agility and responsiveness to market conditions.
Active Management: Fund managers can leverage opportunities in the less-researched small-cap space, potentially enhancing fund performance.
Cyclical Opportunities:Â These stocks may present opportunities to capitalize on economic cycles and sector rotations, leading to higher returns during economic expansion periods.
Conclusion
Small-cap mutual funds offer a compelling opportunity for investors seeking higher potential rewards despite greater risk. Managed by professionals, they target small-cap companies beyond the top 250 in market capitalization. With careful consideration of the associated risks and returns, these funds can serve as a valuable component in building a diversified and robust investment strategy.
Disclaimer: The views expressed here are of the author and do not reflect those of Dhanvantree. Mutual funds are subject to market risks, please read the scheme documents carefully before investing.