What are Small-Cap Mutual Funds – Benefits, Taxation and Risks
What are Small-cap Mutual funds?
A small-cap mutual fund are equity mutual funds that invests at least 65% of the fund corpus in equity shares of small-cap companies. Small-cap (Cap = Capitalisation) companies, according to SEBI, have a market capitalisation of less than Rs. 5000 crore and rank below 250 in the stock market. These small cap mutual funds are highly volatile and are suitable for investors who want to maximise portfolio returns. Small-cap funds are riskier compared to large-cap and midcap funds. Read on the blog to know more about small cap funds.
Features of Small Cap Mutual Funds
Following are the noteworthy features of small cap mutual funds.
1. Market Volatility
Small cap mutual stocks are sensitive to market volatility and risks. That is why market changes like economic factors, investor sentiments, and corporate activities influence small cap funds. These shifts can bring dynamic changes in one’s returns. Owing to the volatile market here, these funds can either fetch huge returns or massive losses.
2. High Risk and High Returns
Unlike large cap mutual funds, small cap ones do not perform well in bearish markets. As a result, small cap funds are riskier than large or mid cap funds. Small cap funds basically invest in emerging companies that perform well when the market is booming. However, a slight fall can negatively impact their performance. On the other hand, when the market is bullish, these small cap funds can generate high returns on investments.
3. Invest in Emerging Companies
Unlike large cap funds that invest in established companies, small cap funds invest in new and emerging firms. These are on the verge of becoming mid and large cap companies. As new companies, these have higher growth potential than mid and small cap funds.
4. Investment Horizon
Small cap funds are suitable for long term investments. The typical investor will likely have an investment horizon of 7 years or more. The risks involved will be spread throughout the investment period and one can make substantial gains by investing.
How do Small-cap Mutual funds Work?
Small cap mutual funds work similarly to other equity mutual funds. Unlike large cap funds, small cap funds invest in young companies and startups. As per SEBI’s mandate, small cap funds need to invest at least 85% of their assets in these companies.
Fund houses launch mutual fund schemes to gather funds from interested investors. The fund managers study the market pattern of small cap companies. They further use the gathered funds to invest in stocks that have a positive future projection. If a stock tends to show downfall or poor growth, they remove or replace them with other shares.
Small cap companies have the potential to generate very high returns along with huge risks. As they are in an emerging state, their stocks can double or triple in value with growth and positive developments of the company. However, the opposite can also happen.
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Advantages of Investing in the best Small Cap Mutual Funds
Small-cap funds offer various benefits to their investors. Some of them have been discussed below:
1. Potential for High Return
One of the main advantages of small-cap funds is their potential for high returns in the long term. The returns can be higher in comparison to mid-cap funds and large-cap funds. This is because small-cap companies have a higher scope for growth and expansion in the future.
2. Diversification
small-cap funds offer much-needed diversification in the portfolio. A diversified portfolio lowers the risk involved in investment. Funds can be invested in various sectors like FMCG, IT, financial services, etc., to mitigate portfolio risk.
3. Growth Possibility
Small companies always have a chance of merging with a large company or corporation. This leads to a substantial surge in the share price, thereby increasing the NAV (Net Asset Value) of the funds that invest in them.
Disadvantages of Small-Cap Mutual Funds
Here are some disadvantages that you should consider before investing in a small cap fund.
1. Risky and Volatile
Small cap mutual funds are highly risky investments. They are sensitive to market uncertainty and carry high volatility. Therefore, investors with a low-risk appetite should avoid investing here.
2. Not Fit for New or Novice Investors
If you are a new investor without much knowledge about the stock market, you may want to avoid investing in small cap mutual funds. Although they promise high returns, you can face major losses on rash investments.
3. Success Depends on Fund Houses and Managers
The success of your investment totally depends on the time and skill of the fund managers researching stocks on your behalf. If a fund manager makes careless decisions while researching the market, you may face massive losses. Therefore, before investing consider knowing the history of the fund manager.
Who should invest in Small Cap Mutual Funds?
Investors who fall in the following categories are fit to invest in small cap mutual funds.
- Seasoned investors who are well aware of the market movements and can predict the future projections of small cap companies
- Investors with a high-risk appetite who can bear massive losses to earn high benefits
- Experienced investors looking for portfolio diversification
- Investors who are ready for long term investments. This means, once you invest funds in small cap mutual funds, you will not withdraw your money or returns before a pre-decided period.
- People with a low-risk appetite must avoid investing here.
- Novice or inexperienced investors should not invest in small cap mutual funds.
How to Invest in Small-Cap Mutual Funds?
Here are a few steps you can follow to invest in small cap mutual funds.
- Step 1: Visit the portal of your broker or mutual fund. You can also download the app of the same if available.
- Step 2: Look for the small cap mutual fund you are planning to invest in.
- Step 3: Type the amount you want to invest in the space given.
- Step 4: Select investment mode and click on Invest Now.
- Step 5: Complete your KYC by entering your basic information like PAN and bank details to complete the investment.
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Risks Involved in Small-Cap Fund Investment
The following are the main risks of investing in small cap funds:
- As small cap companies are relatively new and inexperienced, they find it difficult to endure negative market pressures. While in a growing economy, these companies have tremendous growth potential, in recessions they find it difficult to acquire funds to maintain their operations. Furthermore, they may be acquired by their larger rivals looking to maintain their leadership positions.
- Small cap firms are very sensitive to economic changes due to their fewer resources and smaller economic moats. Thus, a small change in government policy like taxation or foreign policy can send their prices up or down. Investors need to bear this type of risk to invest in small cap mutual funds.
Things to Consider before Investing in small-cap Funds
1. Cost of Investment
small-cap equity funds charge a fee on an annual basis from the investors to cover their operating expenses. It is called the expense ratio. SEBI has fixed the upper limit at 2.25% of the overall assets under management. The lower the charge, the higher will be the gains that an investor earns. So investors should look for funds that charge a low expense ratio.
2. Investment Goals
These mutual funds may not be suitable for fulfilling the short-term goals of investors as these schemes are very volatile. That said, these funds can help in securing the long-term goals of an individual. Long-term goals that might align with these funds’ objectives are financing children’s higher education, building a retirement corpus, buying a house, etc.
3. Fund Manager’s Experience
The performance of a small-cap fund depends upon the efficiency of the fund managers as they take all the investment decisions after doing thorough research and analysis. Hence, it is vital that you check the track record of the fund manager before choosing to invest in a small-cap fund.
Taxation of Small-Cap Mutual Funds
The taxation of small cap mutual funds depends on their holding periods. If the holding period is less than a year, you make short-term capital gains. However, if the holding period is more than a year, you can fetch long term capital gains.
- For short-term capital gains (STCG), the rate of taxation is 15%.
- Long-term capital gains (LTCG) up to ₹1 lakh is tax-free. However, if your gains are above ₹1 lakh, you would be taxed at 10% without indexation benefit.
Final Word
Small-cap mutual funds are an interesting option suitable mainly for aggressive investors. These schemes can help you fulfil your investment goals. That said, before investing in small-cap mutual funds, make sure to consider crucial aspects, such as risk appetite, past returns of the funds, etc. Happy investing!
FAQs
Mutual funds are a very safe investment option once someone understands them properly. Investors should not be worried because of the short-term fluctuations. All top-rated small-cap funds have high return potential if one is patient.
High volatility is the biggest deterrent of these equity funds. Small companies go for aggressive expansion early, so volatility in their share prices tends to occur. Nevertheless, as the company grows, it has the potential to become more stable.
Large-cap funds invest at least 80% of the fund corpus in the equity shares of top 100 companies with regard to market capitalisation. Whereas in small-cap funds, the fund manager must invest at least 65% of the pooled money in equity shares of companies ranked below 250 in terms of market capitalisation.
As small-cap funds primarily deal with small companies that are looking to expand. Hence these companies do not offer high dividends as any excess profit is reinvested back in the business. The returns outlook of small-cap funds in dividends is low to moderate.
Small-cap funds do not come with a lock-in period. Investors can choose to redeem their units in a small-cap mutual fund scheme by placing a request with the asset management company (AMC) at their convenience.
Since small cap mutual funds are ideal for bearing returns for long term investments, you can start investing here as SIP. However, consider researching the small cap fund’s performance before making SIP investments.
Small cap Funds are risky investments for novice investors and ones with low-risk appetite. This is because these small cap funds can rise and fall drastically with frequent market movements.
Small cap mutual funds are good for long term investments as it helps in wealth creation. However, investors must have a high-risk appetite to invest in small cap funds as they are quite volatile in nature.
Experts say that when the market is recovering from its bearish phase to become stable again, it is the best time to invest in small cap funds. Signs like the growing income of businesses and a fall in unemployment reflect that the market is rebounding and you can invest in small cap funds.
When investing in small cap mutual funds, you must be mindful of the fact that these funds have minimum portfolio diversification. Therefore, they are highly volatile and risky. To invest here, consider assessing your risk appetite first. If you have enough capital, you can start investing with a small lump sum or opt for an SIP.
Following are the best small cap mutual funds you can invest in 2023:
• Quant Small Cap Fund
• Kotak Small Cap Fund
• Nippon India Small Cap Fund
• SBI Small Cap Fund
• Axis Small Cap Fund
The best small cap funds based on 5 years are:
• Aditya Birla Sun Life Small Cap Fund
• Sundaram Small Cap Fund
• Franklin India Smaller Companies Fund
• IDBI Small Cap Fund
• DSP BlackRock Small Cap Fund
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
