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, who they might be suitable for, and what to consider before investing. Learn how small-cap funds 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 small-cap companies ranked beyond the top 250 in terms of market capitalization. Managed by professional fund managers, they primarily invest in stocks, offering the potential for higher returns but also carrying higher risk due to market volatility and economic fluctuations.
Small-cap funds typically allocate at least 80% of their assets to small-cap companies, defined by SEBI as those ranking below the 250th position in market capitalization, with market capitalization less than Rs. 5000 crores.
How do Small Cap Funds Work?
Small-cap equity funds primarily allocate at least 65% of their assets to small-cap equities, focusing on companies beyond the top 250 in market capitalization. It is preferred for the Investors who seek high returns over stability, accepting the higher risk of smaller companies. These funds heavily rely on portfolio composition, requiring careful selection to mitigate investment risks. While offering significant long-term returns, small-cap funds are riskier and more volatile in the short to medium term compared to other equity-focused funds.
Despite the higher risk, small-cap stocks can experience rapid growth,, potentially doubling or tripling in value. Investors must acknowledge the perpetual presence of risk inherent in market investments and maintain a long-term perspective while diversifying their portfolio to manage volatility.
Features of Small Cap Funds
Features of Small Cap Funds are:
- High Risk: Small-cap stocks are more volatile than their larger counterparts. The companies are younger and less established, making them more susceptible to economic fluctuations and potentially facing greater challenges.
- Moderate to High Expense Ratios: Actively managed small-cap funds often require more research and analysis, potentially leading to slightly higher expense ratios compared to large-cap funds.
- Lower or No Dividends: Small-cap companies typically prioritise reinvesting profits back into the business to fuel future growth. Dividend payouts are uncommon or minimal compared to larger companies.
- Enhanced Diversification Compared to Large-Cap Funds: Small-cap funds offer exposure to a wider range of companies beyond established giants, potentially reducing portfolio risk compared to a large-cap focus. However, diversification might be lower compared to a total stock market fund.
- Suitable for Long-Term Investment Horizons: The high-risk, high-reward nature of small-cap funds makes them suitable for long-term investment goals (ideally 7 years or more). This allows investors to weather short-term volatility and potentially benefit from long-term company growth.
- Low Liquidity: Small-cap stocks are generally traded less frequently than larger companies. This can make it more difficult to quickly buy or sell your fund units at your desired price.
- Potential for High Returns with High Volatility: Small-cap funds have the potential to outperform other asset classes over the long term. However, this also comes with the potential for significant losses, especially in the short term.
Benefits of Investing in Small-Cap Funds
Discover why Small-Cap Funds could be the perfect fit for your investment goals. The benefits of investing in small-cap funds include:
- High Growth Potential: Small-cap stocks represent innovative companies with significant growth prospects, offering investors the opportunity to benefit from their rapid expansion.
- Diversification: Small-cap funds spread investments across various sectors, reducing the impact of individual stock volatility and enhancing portfolio diversification.
- Potential for Outperformance: Historically, small-cap stocks have outperformed large-cap stocks, driven by their agility and responsiveness to market changes.
- Opportunities for Active Management: Active fund managers can leverage their expertise to identify promising small-cap companies, potentially enhancing fund performance.
- Cyclical Opportunities: Small-cap stocks provide opportunities to capitalize on economic cycles and sector rotations, leading to higher returns during periods of economic expansion.
- Long-Term Investment Horizon: Small-cap funds are suitable for investors with a long-term perspective, offering the potential for significant capital appreciation over time.
- Access to Emerging Trends: Investing in small-cap funds allows investors to gain exposure to emerging technologies and niche markets driving future growth.
- Portfolio Construction: Small-cap funds complement diversified portfolios, offering unique risk-return characteristics and potentially improving overall portfolio performance.
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. This volatility can lead to rapid price fluctuations and increased investment risk.
- Liquidity Risk: Limited liquidity in small-cap stocks can pose challenges in executing trades at desired prices, particularly during market stress, resulting in wider bid-ask spreads.
- Business Risk: Small-cap companies face elevated business risk, including competition, market cyclicality, and regulatory changes, which can impact their financial performance and stock prices.
- Sector Concentration: Small-cap funds often have significant investments in specific sectors, heightening the risk of adverse sector developments affecting fund returns.
- Market Risk: Small-cap stocks are more sensitive to broader market movements and sentiment, which can lead to heightened volatility and potential losses during economic downturns or geopolitical events.
Returns
- Higher Growth Potential: Small-cap stocks offer substantial growth potential compared to large-cap stocks, providing investors with opportunities to benefit from the expansion of dynamic companies.
- Diversification: Small-cap funds offer diversification across sectors and industries, helping to reduce 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: Active fund managers can leverage opportunities in the less-researched small-cap space, potentially enhancing fund performance through skilled stock selection.
- Cyclical Opportunities: Small-cap stocks may present opportunities for investors to capitalise on economic cycles and sector rotations, leading to higher returns during periods of economic expansion.
Conclusion
Small-cap mutual funds offer a compelling opportunity for investors seeking higher potential rewards despite greater risk. Managed by professionals, these funds target small-cap companies beyond the top 250 in market capitalization. With careful consideration of the associated risks and returns, small-cap 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.