What are Small Cap Mutual Funds?

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What are Small Cap Mutual Funds?

Mutual funds are classified according to their investment strategy. The majority of the corpus of equity mutual funds is invested in stock and equity-related products. The Securities and Exchange Board of India (SEBI) has standardised mutual funds based on their category and category-specific characteristics.

Small Cap mutual funds are equities mutual funds. The asset allocation of small-cap funds invests at least 65 per cent of their entire assets in small-cap companies. Small Cap companies are those that rank below 250 by total market capitalization. In other words, these companies have a market capitalization of less than Rs. 5000 crores.

Mutual funds that invest primarily in small-cap equities are open-ended small-cap funds. A minimum of 65% of these funds’ portfolio assets are invested in stock and equity-related products of small-cap companies. Small Cap companies are startups with an aggressive expansion strategy. These securities are more volatile and susceptible to market fluctuations. Small-cap mutual funds are consequently riskier than large-cap, mid-cap, and multi-cap funds.

It is an essential factor that helps investors estimate the returns and risks associated with an investment. According to market capitalisation, mutual fund schemes are classified as large-cap, mid-cap, and small-cap. To diversify their portfolios and eliminate market volatility, investors can allocate 70%, 20%, and 10% of their assets to large-size, mid-cap, and small-cap mutual funds, respectively as per their investment objectives.

The investors’ fundamental purpose is to produce long-term capital growth through investing in small-cap mutual funds. Even though small-cap mutual funds are riskier and more volatile in the short to medium term, historically, they have the potential to generate more significant returns over the long run. The equities of small-cap funds have the potential to increase by a factor of two or three within a short time frame. However, it is prudent to conduct thorough research and invest based on one’s risk tolerance, financial objectives, and liabilities. Most significantly, investors should be patient when investing in small-cap mutual funds. Regular investments in small-cap funds assist in averaging out market volatility and risk. Therefore, investing via SIP will be advantageous in the long run. Moreover, investors should never sell in a panic. Small-cap funds have the potential to make a substantial return over time. However, historical performance is just indicative of the fund’s performance since inception. Investors should not rely heavily on prior results.

List of Top Small Cap Mutual Funds in India (as per 5-year return)

Scheme	5-Year Return	AUM(Cr)
Quant Small Cap Fund	23.09 %	2,219.80
Axis Small Cap Fund	21.27 %	10,943.70
Nippon India Small Cap Fund	19.39 %	22,496.00
SBI Small Cap Fund	19.25 %	14,663.24
Kotak Small Cap Fund	19.17 %	8,593.61

Source: AMFI ( Data as of 21/09/2022)

Features of Small Cap Mutual Funds

The best small-cap mutual funds provide investors with the chance to earn returns from emerging companies. Nonetheless, small-cap funds and stocks are susceptible to market risk. Before investing in funds, investors should understand how they operate and assess their advantages and cons. The features of small-cap mutual funds are listed below.

Returns: The best small-cap mutual funds have the potential to outperform the market in terms of returns. Since small-cap mutual funds invest primarily in small-cap companies, they tend to share the same advantages and disadvantages as small-cap equities. During bull markets, small-cap stocks frequently appear on the list of high-yielding stocks. These stocks frequently appear on the list of multi-baggers. However, in a bear market, returns may be significantly reduced or even negative. One can always utilise the SIP calculator on Kuvera to determine the possible SIP returns of a small-cap mutual fund.

High Risk: Small-cap mutual funds are riskier than large- and mid-cap funds due to their potential for greater returns. This is primarily due to the fact that, unlike small caps, large and midcap companies are better able to endure bad events. Large-cap companies are established businesses, and as a result, they are less susceptible to negative market attitudes than smaller ones. On the other hand, small-cap companies are emerging businesses in the process of becoming mid- and large-cap companies. Even a minor market decline can negatively impact these companies.

Investment Period: The best small cap mutual funds have a long-term investment horizon. Any investments made in these funds are required to be held for at least seven years. There is no absolute rule regarding it. Typically, long-term investments help to mitigate the associated risks and provide significant returns.

Volatility: Small-cap mutual funds are highly susceptible to market conditions and, as a result, are highly volatile. Small-cap stocks respond swiftly to market fluctuations. These equities are influenced by investor sentiment, economic circumstances, business activities, etc. This volatility can result in market-beating returns or negatively affect the returns of small-cap mutual funds.

Small cap companies: Small cap mutual funds portfolio invests in small-cap companies. These are companies with modest revenues and sometimes startups in the earliest stages of their development. Since the companies are very young, their growth potential is relatively greater than that of large and mid-cap funds.

Who Should Invest In Best Small Cap Mutual Funds?

Small cap mutual funds are for ambitious investors who are willing to remain invested for a prolonged period of time.

Small cap mutual funds are better suited for investors with a high-risk tolerance due to their high volatility.

Small cap mutual funds are designed for investors who are comfortable with portfolio value swings; consequently, it is prudent to invest only a small amount of one’s portfolio in small-cap mutual funds.

When investing in small cap mutual funds, it is recommended to use systematic investment plans (SIPs) rather than the lump payment technique. Rupee cost averaging would be advantageous to investors and minimise the cost of holding.

Lastly, an investor should not invest more than 10 to 15 per cent of their stock exposure and should carefully align their investment portfolio with their financial objectives.

Taxability of Best Small Cap Funds

Capital gains tax applies to small cap mutual funds. They are taxed based on the duration of the investment. The capital gains tax is decided by the investment’s holding period. Small cap equity mutual funds invest mostly in small cap equities (65%). Consequently, these funds are taxed as equity funds.

Short Term Capital Gains Tax (STCG): Investments held for less than a year are subject to a 15% p.a. (plus 4% CESS) tax on capital gains.

Long Term Capital Gains Tax (LTCG): For holding periods longer than a year, gains are taxed at a rate of 10% each year (plus 4% CESS). Gains up to INR 1 Lakh are exempt from LTCG.

Effective on April 1, 2020, dividends will be taxed in the hands of the investor. Dividends are added to the individual’s taxable income and taxed based on the income tax slab rate. For dividends above INR 5,000, a 10% TDS is deducted.

In addition, investors who sell their holdings in equity mutual funds are subject to a securities transaction tax of 0.001%.

Risk Possessed by Small Cap Mutual Funds

If you are interested in investing in small cap funds in India, you must also be aware of the investment’s related risks. Here are the potential risks you may encounter when investing in small-cap funds:

Small-cap stock price volatility

The stock market is constantly turbulent. Therefore stock values might fluctuate over time. It is because small-cap stocks do not generate a substantial amount of cash flow and are less established as compared to large and mid-cap companies. This volatility can cause stock values to fluctuate significantly. Establishing a continuous income stream from small-cap companies is difficult if the investor seeks one. Here small-cap stocks are relevant because small-cap funds predominantly invest in small-cap companies.

Typical Duration of an Investment in small-cap funds

Generally, if you are patient, you can generate profits quickly by investing in small-cap funds; however, this is only true if you wait a long period between the sale and purchase of the fund units. If you are in need of quick gains, investing in small-cap funds is not the best option.

Additional risk concerns for small-cap funds:

Small-cap funds are typically regarded as high-risk investments because small-cap companies are less well-known among investors than large-cap and mid-cap companies. Therefore, NAV of small-cap funds can fluctuate substantially for the same reason.

Returns on investments in small-cap funds

Small-cap funds have the potential to provide greater returns than large-cap ones. However, you should also be aware that the returns you would earn from investing in small-cap companies/funds are inconsistent. Occasionally, they may provide you with more significant returns concurrently, but they may also underperform over a particular tenure.

Things an Investor Should Consider When Investing in Best Small Cap Mutual Funds

Small-cap mutual funds are susceptible to a substantial amount of market risk, and investors are advised to consider all of the elements that affect the performance of these funds. You must consider things such as the amount of risk you are willing to assume, your investing objective, etc.

Before selecting to invest in the finest small-cap funds, there are a number of important considerations to keep in mind.

Investment Risk: Even the finest small-cap mutual funds carry a significant amount of risk, but there are also funds that can manage these risks and generate profitable returns. One should examine the numerous funds that have outperformed the Small Cap benchmark and other small-cap funds in order to ensure that they are receiving both profitable and low-risk returns.

Small-cap mutual funds typically provide high returns and might be an excellent addition to your portfolio. With a large amount of risk, you may assure that these funds serve as high-value portfolio buffers should the market perform well for them.

Cost: Small-cap equity funds incur expenses to ensure your investment is properly handled. This is known as a fund’s expense ratio. SEBI’s guidelines limit the expense ratio of a fund to 2.50 per cent. When selecting a fund, it is advised to evaluate the fund’s net return after expenses.

Investment Goal: When the market begins to decline, even the best small-cap mutual funds can experience significant erosion in their returns. Consequently, if you want to maximise the return on your investment, you should invest for a long-term purpose, such as the education of your children, saving for your retirement, purchasing a home, and so on.

Taxation: capital gains obtained while redeeming small-cap equity funds are taxed based on the length of time the sum was invested, often known as the holding period.

Performance: Prior to investing, investors should evaluate the performance of small-cap mutual funds during the previous four to five years. Small cap mutual funds are diverse, unlike large cap mutual funds. Four to five years of consistent performance of small-cap mutual funds is a good indicator of the performance of mutual funds. However, historical returns do not indicate guaranteed returns.

Advantages of Best Small Cap Mutual Funds

Growth potential: Small-cap mutual funds invest in small-cap companies with high growth potential. They are relatively younger and smaller than large and midcap companies. They are in the early phases of their life cycle, affording them tremendous growth potential.

Adaptability: Small-cap stocks have a high degree of adaptability to market situations. Their small stature allows them to react to any market changes. This aids in protecting the stocks’ support levels in bad times.

Fairly priced: The best small cap funds invest in under-followed small cap stocks. Consequently, small-cap fund managers incorporate reasonably priced, high-quality stocks in their portfolios. This may raise the likelihood of obtaining market-beating returns.

Diversification: Top small-cap funds boost portfolio diversification. To widen their portfolio and diversify their sector allocation, investors in large and mid-cap stocks can invest in small-cap stocks. Small-cap funds have the potential to provide higher returns than large and mid-cap funds during the bullish phase. Therefore, including these in a portfolio will not only create diversification but can also increase the portfolio’s returns.

Returns: If invested in the right stocks at the appropriate moment, the best small cap mutual funds have the potential to provide big market-beating returns. To enhance returns, small-cap fund managers conduct considerable research to select high-yielding stocks for the portfolio. In a bull market, their returns can be greater than those of pure large-cap funds or even multi-cap funds.

SIP and long-term investments: Small-cap funds can be invested via SIP and lump sum. While both methods of investment can generate good returns, SIP investments can increase profits. Investors do not need to worry about the time of their investments because they make SIP investments. This is due to their long-term, recurrent investments in these funds, which cover all market cycles. This improves the risk management of investing in small-cap stocks and spreads out the cost of investment. And also increases returns through compounding power—this aids in accomplishing their financial objectives.

Conclusion

Small-cap mutual funds offer an outstanding opportunity to increase returns and diversify portfolio risk. Even though they generate favourable returns during a bull market, they are the riskiest mutual funds. In adverse market situations, their returns may be negatively affected. Therefore, investors should be aware that small-cap equity funds alone are insufficient for generating high returns. By following certain steps, investors can reduce the risk of investing in small-cap funds.

Other alternative investment options, such as large-cap equity funds (bluechip funds), mid-cap equity funds, multi-cap equity funds, and hybrid funds, all provide the possibility of earning good returns with modest risk. Investors may consider a debt fund for low risk and a predictable return. Investors may consider investing in these to diversify their portfolios. In addition, the online SIP calculator provided by kuvera can be used to determine the possible SIP return on investments.

Avoid buying or selling investments in small-cap funds in a rush. Short-term gains and losses are both ephemeral. Therefore, investors should not rush and instead can invest for the long term (minimum of seven years).

FAQs

Where do small-cap funds invest?

Small-cap funds invest in equities outside the top 250 companies (based on market capitalisation), i.e. small-cap companies.

How risky are small-cap investments?

They have high growth potential. However, they rank highly risky in terms of risk profile.

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