Small-cap mutual funds are a popular type of equity mutual fund that primarily invests a minimum of 85% of its assets in the stocks of small companies. The Securities and Exchange Board of India has defined small-cap firms as those companies that are ranked below 251 in terms of their market capitalization.

Notably, small-cap mutual funds are known for their high-risk and high-return-generating investments. This is because small companies are deemed more volatile when compared to large companies. During the bear phase of the market, the stock prices of these companies can fluctuate sharply prompting more loss. However, small companies have the potential for rapid growth, and their stocks yield high returns over time. 

Features of Small Cap Mutual Funds

Asset allocation: Small-cap funds have to invest a minimum of 65% of their total assets in small-cap stocks, i.e., shares of companies that are ranked after 250 companies based on the size of their market capitalization. Small companies are deemed to have more potential to grow than other firms. Hence, small-cap funds tend to have more potential to yield higher returns compared to types of equity funds.

Volatile: Small-cap mutual funds are considered to be highly volatile as they mostly invest in small companies that are more susceptible to react to market swings. This means the small companies in question can experience substantial losses under the impact of a bear market, but they can also yield high returns for investors during the bull phase of the market.

Tax implications: Smallcap mutual fund gains are taxed based on how long their units were held by the investors. Typically, gains made on small call fund units held for less than a year are categorized as Short-term capital gains (STCG) and attract STCG tax at the rate of 15% regardless of the investors’ slab. On the other hand, fund units held for more than a year are subject to Long-term capital gains (LTCG) tax. However, LTCG of up to Rs. 1 lakh in a year is tax-free and anything beyond it attracts tax at the rate of 10%.

Investors can introduce small-cap mutual funds into their investment portfolios to diversify them and pave the way to generate above-average ROI. Small-cap funds are riskier than investments made in larger companies, as small-cap companies are considered to be relatively unstable and unable to shoulder huge market losses during the bear phase. Hence, before investing in units of small-cap mutual funds, investors must understand the associated risks involved and become familiar with what are index funds and the types that mimic the market performance of small-cap stocks to make a smart choice.

Is Small Cap Mutual Fund Suited for You?

Small-cap mutual funds are known to be riskier than many other equity mutual funds because small-cap companies are often perceived to be less stable and significantly more likely to fail, especially during the bear market phase. This notion is mostly because small-cap funds have weaker financial standings and are not well-known compared to other larger companies.

However, during the bull phase, these small-cap funds can yield much higher returns when compared to mid and large-cap mutual funds. This is because most small companies have the scope to grow more rapidly than larger companies. The funds often outperform established company funds and help generate substantial returns.

However, whether small-cap funds are the best for you is purely subjection and depends on several factors. 

For instance, individuals need to factor in the following to decide whether the funds meet the mark or not –

Investment goal and time horizon: Different investors have different investment goals, such as buying a vehicle or a house or saving for their retirement. Each of the goals is unique, hence, they require a distinct investment approach and strategy for asset allocation. For example, someone who wants to save to make a down payment on a property will be more comfortable with having a conservative investment portfolio compared to young working individuals saving for their retirement. This is because they are focused on saving a substantial amount of money in the short term and do not want to take the risk of losing their savings in the stock market due to market volatility. Alternatively, those saving for their retirement have a longer time horizon. This makes them capable of facing more risks and suited for investing heavily in stocks. Such a move can help them generate higher returns over time, especially when the market is favorable.

Risk-taking capacity: Experts highly recommend that before putting money in any mutual fund, including a small-cap fund, individuals must factor in their risk tolerance level. Small-cap mutual funds are widely considered to be a volatile investment option, making them best suited for those investors with a high tolerance level for market risk and the ability to recover quickly from losses. Investors with limited financial obligations may also be comfortable with investing in small-cap funds.

Advantages of Small cap Mutual Funds

These are some of the most common benefits of small-cap mutual funds –

  • Growth potential: Small-cap companies are known to be highly aggressive in their expansion strategies, which can ensure significant growth in investment and long-term profitability. This trait makes small-cap mutual funds a good option for many investors to grow their share of wealth over time.
  • Diversification: Including small-cap funds in an investment portfolio can enable investors to diversify their risk and enhance their returns on investment. Small-cap company stocks are known to generate substantially higher returns during the bull phase of the market and can help investors earn inflation-adjusted returns. This way the high returns help make up for the loss in the long run and spread out the impact of the same in the long run.

Small-cap mutual funds come with a high risk-reward aspect. This makes it imperative for individuals to assess their personal risk-taking capacity, actual financial goals, and their timeline for investment to allocate resources in the funds accordingly. Individuals should also reallocate assets in portfolios as per the market sentiment to spread out the impact of risk and generate steady returns.