Small cap mutual funds are the type of equity mutual funds that invest the majority of assets into small-cap companies. Companies from 250 and above rank on market capitalization fall under small-cap. These are relatively new companies trying to grow rapidly.
Compared to large-cap and mid-cap, small-cap companies are rather unstable and riskier to invest in. But small-cap funds may offer you higher returns than any other equity funds.
If your portfolio can take up some risk, and if you prefer returns over stability, small-cap funds are for you. Before you invest, below are some things that you need to know about small-cap equity mutual funds.
As per the quarterly released market capitalization chart by AMFI (The Association of Mutual Funds in India), small-cap fund companies are ranked 250 and above. Fund houses follow SEBI’s guidelines to allocate at least 65% of total assets to small-cap companies. Fund managers analyze the market to decide whether to allocate remaining assets into large-cap, mid-cap, or other equity funds.
As small-cap companies are in the process of expansion and diversification, there’s great potential for growth.
These companies, even though slightly unstable or riskier, may offer higher returns.
Some of the small-cap companies are underrecognized. The stocks of these companies have high growth potential. Investors can buy units at a reasonable price and earn a superior risk-adjusted return over the years.
Small-cap funds can diversify your investment portfolio if you are willing to take some risk. Investors who have an appetite for risk and can trade off stability will benefit from small-cap funds. These funds have the scope to outperform large or mid-cap funds, thereby generating alpha in your portfolio.
It is possible that a well-performing small-cap company will get merged/acquired by a larger company. A merger or acquisition can boost the value of a small-cap company. This opportunity may deliver more than expected returns.
Small-cap companies may or may not perform well. There is also a chance of these companies shutting down or going into financial ruin. Invest in small-cap funds only if you are aware of the higher risk factor associated with them.
Small-cap funds can boost up overnight or can go down drastically. The fluctuations in price range can be rapid, making these funds highly volatile. To stabilize your returns and minimize risk, we recommend starting a SIP with small-cap funds. SIP may safeguard your returns during market ups and downs.
Small-cap companies may or may not publish information about their performance. As an investor, you cannot get enough information about the small-cap company compared to large or mid-cap. In most cases, fund managers do the research to shortlist small-cap companies for the funds. But you might not receive these updates, which creates a lack of transparency.
Some fund houses may charge higher expense ratios to handle highly volatile small-cap funds in your favor. Compare the expense ratio with the net returns you might earn. Note that a higher expense ratio can be beneficial in terms of total returns. In some cases, even if the expense ratio is high, the returns are also higher. When comparing the expense ratio, mapping it with returns will give you a better idea of the scheme.
The taxation on capital gains earned after redeeming the small-cap funds is taxed similarly to all equity funds. It is based on how long the investment was held.
Investors have to pay a 20% tax on Short Term Capital Gains (investments held for less than 12 months). And only 12.5% on Long Term Capital Gains above INR 1.25 lakhs (investment held for more than a year).
You should only invest in small-cap funds if you have a high-risk appetite and at least 5 years of the investment horizon. Your portfolio must be able to tolerate small-cap volatility without causing severe losses. Allocation to small-cap funds should ideally be restricted to 10% of your overall equity portfolio.
Small-cap funds diversify your portfolio by allocating assets to growing small-cap companies. Investors are most likely to receive higher returns with small-cap funds. We would recommend only 8-10% of your total investment in small-cap funds. Large-cap funds are supposed to be the core part of your investment whereas small-cap can be the satellite.
Note: Core and Satellite is a portfolio construction strategy to balance risk, returns, liability and taxation. The core investments are passively managed and are safer. Satellite investments are actively managed and may have slight risk associated with them.
To understand more about equity funds and how to construct your investment portfolio, get in touch with VNN Wealth Experts.
