What Are Small-Cap Mutual Funds: Benefits, Taxation And How To You Invest
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5 May 2022A small-cap mutual fund is an equity mutual fund that invests at least 65% of the fund corpus in equity shares of small-cap companies. These funds are highly volatile and are suitable for investors who want to maximise portfolio returns. But they come with a higher risk. So, should you invest? Do the benefits outweigh the risks?
Get to the bottom of it by understanding what are small-cap mutual funds, how they work, benefits, taxation and things to consider if you decide to invest. Read on!
Small-Cap Mutual Funds Meaning And How Do They Work
Small-Cap Mutual Funds are those that invest majorly in the 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 companies have the potential to grow and produce considerable returns in a short period of time. Small-cap funds are riskier compared to large-cap funds. However, they also come with a set of benefits as listed below.
Benefits of Small-Cap Mutual Funds
small-cap funds offer various benefits to their investors. Some of them have been discussed below:
- 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.
- 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.
- 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.
Also Read: Small, Mid And Large Cap Funds: A Detailed Comparison Before You Invest!
Taxation of Small-Cap Mutual Funds
Mutual funds offer returns to investors in two ways – dividends and capital gains. However, when it comes to small-cap funds, they rarely give dividends to their investors because any excess cash they are left with will be reinvested back in the business. So, a major chunk of returns in this category comes from capital gains.
Capital gains, in simple terms, are the increase in the price of mutual fund units held by the investors. Whenever an individual sells units of mutual funds at an increased price, he/she gets capital gains. It is of two types – short-term capital gains and long-term capital gains.
If the holding period is less than one year, then profits from small-cap funds are taxed under the short-term capital gains category. The rate of taxation is 15%. However, if the holding period is more than one year, then the gains are classified as long-term capital gains. LTCG of up to one lakh is tax-free, and any gains above this amount are taxed at 10% without indexation benefit.
Should You Invest in Small-Cap Funds?
If you want higher returns within a short period of time and are not risk-averse, you can invest in small-cap mutual funds. small-cap funds are highly volatile in nature. They are one of the riskiest mutual funds as they can give exorbitant returns to investors or bring substantial losses. So, these schemes are not at all suitable for risk-averse investors. However, aggressive investors might prefer these funds. Experts suggest that diversification of the portfolio can be a smart way of managing the turbulent nature of these funds. A lot of patience on the part of the investors is required while they are dealing with this category of mutual funds.
If you want less risk exposure, you can opt for more stable options like large-cap funds or large and mid-cap funds offered by Navi Mutual Fund. Start investing with an amount as low as Rs. 500 to fulfil your financial goals.
Things to Consider before Investing in small-cap Funds
- 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.
- 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.
- 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.
Also Read: 10 Best Small Cap Mutual Funds To Invest In 2022
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 on Small-Cap Mutual Funds
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
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