Small Cap Mutual Funds
Small cap mutual funds are equity schemes that invest primarily in companies ranked outside the largest 250 listed enterprises in India. Many financial websites define this category using an outdated ₹5,000 crore market capitalization ceiling. This guide clarifies the official regulatory ranking mechanism, statutory portfolio allocation limits, liquidity considerations, and current capital gains tax rules under the Income-tax Act 2025.
Dhanvantri Capital Services Private Limited, known as Dhanvantree, is an AMFI-registered mutual fund and Specialised Investment Fund distributor, ARN-194216, and a distributor of portfolio management services registered with APMI, APRN10201. We are not registered investment advisers. We name no scheme on this page. The choice is yours.
Regulatory classification: Stocks ranked 251st and beyond by full market capitalization in AMFI’s classification list
Portfolio allocation mandate: Minimum 65% of total assets in equity and equity-related instruments of small cap companies
Large and mid cap tiers: 1st to 100th companies for large cap; 101st to 250th companies for mid cap
Dynamic classification: Relative market capitalization ranking updates twice every calendar year
Tax governance: Sections 196 and 198 of the Income-tax Act 2025 for qualifying equity-oriented funds
How SEBI defines small cap mutual funds
Market capitalisation rank, not a rupee figure, decides which companies a small cap scheme may hold. Companies placed 251st and below on AMFI’s half-yearly list form the segment. Large caps occupy the first 100 places and mid caps the next 150. Rankings are revised twice every calendar year.
The Securities and Exchange Board of India sets the classification under the SEBI (Mutual Funds) Regulations 2026, which replaced the 1996 regime on 1 April 2026. The regulations fix the boundaries by position in a list. They do not fix them by a rupee amount.
AMFI prepares that list. It averages the full market capitalisation of every listed company over a six-month period and ranks them. Every asset management company then works from the same list, so one firm cannot call a company small cap while another calls it mid cap.
| Category | Company Rank by Market Capitalization | Boundary Determination |
|---|---|---|
| Large Cap | 1st to 100th company | 100th company rank on AMFI list |
| Mid Cap | 101st to 250th company | 250th company rank on AMFI list |
| Small Cap | 251st company onward | Stocks ranked 251st and beyond on AMFI list |
Why the ₹5,000 crore figure is wrong
A ₹5,000 crore ceiling was a reasonable description of the segment many years ago. It is not the regulation, and it was never the regulation. Repeating it produces a specific error: it suggests the boundary stands still while the market moves.
Boundaries move with the market. When Indian equity valuations rise across the board, the company sitting at rank 250 is worth more than it was at the last revision. A company valued at ₹10,000 crore may sit comfortably inside the small cap segment today. Under a fixed ceiling it would have been classified as mid cap. The rank-based system exists so that category definitions do not drift as the economy grows.
The 65 percent allocation rule
Allocation rules require a small cap scheme to keep at least 65 percent of total assets in equity and equity-related instruments of small cap companies. The remaining 35 percent may sit in other equities, debt or money market instruments. Scheme documents set out how each fund uses that allowance.
The 65 percent floor is what separates the label from the portfolio. Without it, a scheme could call itself small cap and hold mostly large companies. With it, at least two-thirds of the money must stay in shares of companies ranked 251st or lower.
The 35 percent balance has a purpose. It gives the fund manager somewhere to hold cash when subscriptions arrive faster than the portfolio can absorb them, and somewhere to park money when selling a holding would move its price. Holding part of the portfolio outside small caps does not shield the scheme from a broad market fall.
What the February 2026 circular changed
SEBI circular HO/24/13/15(2)2026-IMD-RAC4/I/5764/2026, dated 26 February 2026, raised the minimum equity allocation from 65 percent to 80 percent for five scheme categories: Dividend Yield, Value, Contra, Focused and Equity Linked Savings Schemes.
Small cap mutual funds were not in that list. The floor for this category remains 65 percent. Pages that describe an 80 percent minimum for small cap schemes are applying the wrong half of the circular.
The reason the floor was left alone is practical. Shares of smaller companies trade in lower volumes, so a manager forced to stay 80 percent invested would have less room to handle redemptions without selling into a thin market.
Allocation limits differ across the equity categories. Our page on types of mutual funds sets out the main ones, and multi cap funds covers a category with a very different mandate.
Small cap and mid cap compared
Rank boundaries produce real differences in how the two categories behave. Mid cap schemes hold companies ranked 101st to 250th. Small cap schemes hold companies from 251st down. The two groups differ in daily trading volume, in how much analyst coverage they attract, and in how far prices move on a large order.
| Parameter | Mid cap | Small cap |
|---|---|---|
| Stock universe | Ranks 101 to 250 | Rank 251 onward |
| Minimum allocation | 65% in mid cap equity | 65% in small cap equity |
| Number of companies | 150 | Several thousand |
| Analyst coverage | Generally broad | Often limited |
| Trading volume | Generally higher | Generally lower |
| Price impact on large orders | Lower | Higher |
Mid cap companies are usually established businesses with a public track record and access to bank credit. Research desks follow them. Their shares change hands in enough volume that a fund can build or exit a position without distorting the price.
The small cap universe is far wider and far more mixed. It holds companies that sit just below the 250th rank alongside much smaller regional businesses. Many receive no independent research coverage at all, so the fund manager’s own analysis carries more weight in the decision.
The risks in this category
Risk in small cap mutual funds comes from the shares themselves, not from the scheme structure. Lower trading volumes make large orders expensive to execute. Earnings at smaller companies swing harder through an economic cycle. Information is thinner. Prices move further in both directions than they do for larger companies.
Trading volume and impact cost
Shares of smaller companies trade in lower daily volumes on the BSE and the NSE. When a fund buys or sells a large quantity, there may be no counterparty ready at the quoted price. The order itself moves the price. That difference between the expected price and the executed price is impact cost, and it comes out of the returns unitholders receive.
Earnings swing harder
Smaller companies often sell fewer products into fewer markets. A single lost contract, a raw material price move or a rise in borrowing costs can change the profit figure sharply. Larger companies absorb the same shock across more business lines.
Less information to work with
Rating agencies, research desks and financial media follow large companies closely. Coverage thins quickly below the mid cap boundary and disappears entirely for many small caps. Verifying management quality and accounting practice becomes the fund house’s own work.
Wider price swings
Small cap shares have historically moved further than large caps in both directions. Rises during market expansions have been larger. Falls during contractions have also been larger. An investor who cannot hold through a decline will be selling at the worst point of the cycle. Our page on index funds covers a structurally different approach to equity exposure.
Mutual fund investments are subject to market risks. Nothing on this page indicates how any scheme will perform.
How small cap mutual funds are taxed
Tax treatment depends on the portfolio, not on the category name. A scheme is taxed as an equity-oriented fund only if it satisfies Section 198(8) of the Income-tax Act 2025. Where it does, gains on units held up to 12 months fall under Section 196 and longer holdings under Section 198.
The Income-tax Act 2025 replaced the Income-tax Act 1961 on 1 April 2026. Section 196 is the corresponding provision for the short-term rule previously in Section 111A. Section 198 is the corresponding provision for the long-term rule previously in Section 112A.
Section 198(8), clause (I), sets the qualifying test. At least 65 percent of the scheme’s investible proceeds must be invested in equity shares of domestic companies listed on a recognised stock exchange. The percentage is computed as the annual average of the monthly averages of the opening and closing figures. A continuous holding requirement appears in clause (II), but that clause applies to specified insurance policies, not to mutual fund schemes. Where a scheme qualifies, the
Income Tax Department
applies two rates:
| Holding period | Section | Rate | Threshold |
|---|---|---|---|
| Up to 12 months | 196 | 20% | None |
| Over 12 months | 198 | 12.5% | Gains above ₹1,25,000 in the year |
Both rates apply only where Securities Transaction Tax was paid on the transfer. A 4 percent health and education cess is added to the tax calculated. Surcharge applies separately at higher income levels.
The ₹1,25,000 threshold is an annual figure and it is shared. It covers qualifying long-term gains across listed equity shares, units of equity-oriented funds and units of business trusts taken together, not ₹1,25,000 for each.
We are not tax advisers. Confirm your own position with a chartered accountant.
A worked example
An investor buys units of a qualifying equity scheme for ₹5,00,000 on 10 May 2025 and redeems the whole holding for ₹7,00,000 on 20 June 2026.
| Step | Amount |
|---|---|
| Redemption proceeds | ₹7,00,000 |
| Cost of acquisition | ₹5,00,000 |
| Gain | ₹2,00,000 |
| Holding period | 13 months, so long-term |
| Annual threshold | ₹1,25,000 |
| Taxable gain | ₹75,000 |
| Tax at 12.5% | ₹9,375 |
| Cess at 4% | ₹375 |
| Total | ₹9,750 |
The example assumes a resident individual, no other qualifying long-term gains in the year, no surcharge, and STT paid on the transfer. Change any of those and the figure changes.
Had the same units been sold within 12 months, the full ₹2,00,000 would have been taxed at 20 percent under Section 196, with no threshold, giving ₹40,000 plus ₹1,600 cess.
Switching units from one scheme to another counts as a redemption followed by a fresh purchase. Tax falls due on the switch date. Our page on long term capital gain tax on mutual funds covers the computation in more detail.
An exit load may also apply when units are sold early. Terms are set by each scheme rather than by the category, and the current Scheme Information Document is the only reliable source for a given fund. Our page on exit load explains how the deduction works.
Common Questions
SEBI defines them as open-ended equity schemes holding at least 65 percent of total assets in equity and equity-related instruments of small cap companies. Small cap companies are those ranked 251st and below by full market capitalisation on AMFI’s half-yearly list.
No fixed rupee limit applies. The boundary is a position on a list, and the rupee value at that position changes every time AMFI republishes it. A ₹5,000 crore ceiling is sometimes quoted but has no basis in the current regulations.
No. Circular HO/24/13/15(2)2026-IMD-RAC4/I/5764/2026 of 26 February 2026 raised the floor to 80 percent for Dividend Yield, Value, Contra, Focused and ELSS schemes only. Small cap mutual funds remain at 65 percent.
Gains on units held up to 12 months are taxed at 20 percent under Section 196. Gains on units held longer are taxed at 12.5 percent under Section 198, on the amount above ₹1,25,000 for the year. Both need STT paid on transfer, and 4 percent cess is added.
A company that rises past rank 250 at the next AMFI revision stops counting toward the 65 percent floor. The scheme then holds the share within its 35 percent allowance or sells it over time. SEBI allows a rebalancing window for deviations that arise this way.
Into other equities, debt securities or money market instruments, within the limits in the scheme’s offer document. Each fund discloses its own use of that allowance.
Returns, Form 16, Form 26AS and capital gain statements for at least six years after the end of the relevant tax year. Keep purchase records for anything you still hold for as long as you hold it. You will need the acquisition cost whenever you eventually sell.
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.