Small Cap Fund: Features, Benefits, and Risks Explained in Detail

0 min read

Small Cap Fund offers high growth potential by investing in emerging companies. While they can deliver substantial returns, they also come with higher volatility, making them suitable for long-term, risk-tolerant investors.

In this article, we will examine the features, benefits, and risks associated with small-cap funds in detail.

What is a Small Cap Fund?

A Small Cap Fund is an equity mutual fund that primarily invests in small-cap stock companies that rank 251st and beyond in terms of market capitalization, under ₹5,000 crore, as per SEBI classification.

These funds are known for their high growth potential, but they also carry higher risks and volatility than large-cap and mid-cap funds.

Understanding Small Cap Stocks

Small-cap stocks belong to companies that are in their early stages of growth. These firms may be market disruptors or emerging industry leaders, offering investors a chance to benefit from early-stage growth.

However, since these companies are smaller in size, they lack financial stability compared to large-cap firms, making them more vulnerable to market downturns.

For example, if a small-cap fund invests in a rapidly growing tech startup, its stock price can increase significantly, boosting investor returns.

Key Features of Small Cap Fund

High Growth Potential: Small companies have a greater chance of expansion.

Higher Volatility: More sensitive to market fluctuations.

Long-Term Investment Horizon: Suitable for investors willing to hold for 5-10 years.

Investment in Emerging Businesses: Targets companies with strong fundamentals and potential for becoming large caps in the future.

Professional Management: Fund managers carefully analyze and pick promising small-cap stocks.

Working of Cap Fund Work

• Fund managers select high-potential small-cap stocks based on growth prospects, industry trends, and financial performance.
• Aims to outperform the benchmark index (e.g., Nifty Smallcap 250 Index).
• Due to market volatility, fund managers frequently rebalance the portfolio.

Popular Small Cap Mutual Funds in India

Below is a table highlighting some of the top-performing small-cap mutual funds in India:​

(Please note that past performance does not guarantee future results. Investing in small-cap funds carries higher risks due to market volatility. It's essential to assess your risk tolerance and investment horizon before investing.)

Comparison of Small-Cap, Mid-Cap, and Large-Cap Mutual Funds

Who Should Invest in Small Cap Mutual Fund?

Small-cap mutual funds are high-risk, high-reward investments that are best suited for specific types of investors. Here’s who should consider investing in them:

Investors with High-Risk Tolerance

• Small-cap stocks are highly volatile and can experience sharp price swings.
• Ideal for those comfortable with short-term fluctuations for long-term gains.

Long-Term Investors (5+ Years Investment Horizon)

• Small-cap stocks take time to grow and deliver substantial returns.
• A long-term approach helps ride out market volatility.

Investors Looking for High Growth Potential

• Small-cap funds focus on emerging companies with high growth potential.
• Suitable for investors seeking aggressive wealth creation.

Experienced Investors & Market-Savvy Individuals

• Requires understanding of market trends, fund performance, and risk management.
• Not ideal for beginners without guidance.

Investors Looking to Diversify Their Portfolio

• Can complement large-cap and mid-cap investments for a balanced portfolio.
• Helps capture growth opportunities in the small-cap segment.

Key Considerations Before Investing in Small Cap Fund

Small-cap funds offer high rewards but come with risks. Consider these key factors before investing:

Risk Tolerance

• Small-cap funds are highly volatile and can experience sharp price fluctuations.
• Investors should be comfortable with short-term market swings and potential losses.

Investment Horizon

• Small-cap companies take time to grow; therefore, a long-term investment horizon (5+ years) is recommended.
• Short-term investors may struggle with market corrections and liquidity issues.

Fund Performance & Track Record

• Check the historical performance of the fund over 5–10 years.
• Compare returns against benchmarks (Nifty Smallcap 250 Index) and peer funds.

Fund Manager’s Expertise

• Small-cap funds require active management due to their volatile nature.
• Assess the experience and track record of the fund manager in handling small-cap portfolios.

Expense Ratio & Exit Load

• Expense ratio: Higher expense ratios can reduce overall returns. Look for a fund with a reasonable fee.
• Exit load: Some funds charge fees if you withdraw within a certain timeframe.

Market Conditions & Liquidity

• Small-cap stocks are less liquid, meaning they can be harder to sell during market downturns.
• Consider broader market conditions before investing heavily.

Diversification & Asset Allocation

• Avoid investing 100% in small-cap funds—diversify with large-cap or mid-cap funds for balance.
• Maintain sector diversification within small-cap investments.

Tax Implications

• Short-Term Capital Gains (STCG): Taxed at 15% if sold within 1 year.
• Long-Term Capital Gains (LTCG): Gains above ₹1 lakh are taxed at 10% without indexation benefits.

SIP vs. Lump Sum Investment

• SIP (Systematic Investment Plan): Ideal for reducing risk and benefiting from rupee cost averaging.
• Lump Sum: Can be riskier in volatile markets but may provide higher returns if timed well.

Exit Strategy & Rebalancing

• Monitor fund performance regularly and rebalance if needed.
• Exit if the fund underperforms consistently or market conditions change.

Benefits of Investing in Small Cap Mutual Fund

Small-cap mutual funds carry higher risk but offer strong growth potential over the long term. Below are the key advantages of investing in small-cap funds:

High Growth Potential 

• Small-cap companies have a higher potential for rapid growth compared to mid-cap and large-cap companies.
• Many small-cap stocks eventually grow into mid-cap or large-cap stocks, leading to multi-bagger returns.
• Historically, small-cap funds have outperformed large-cap funds in bull markets.

Early Investments in Future Market Leaders

• Investing in small-cap funds gives exposure to companies before they become well-known market leaders.
• Investors can benefit from a first-mover advantage before institutional investors start investing in them.

Diversification Benefits

• Small-cap funds invest in a broad range of industries, reducing the risk associated with a single sector.
• They often include companies in niche and emerging industries that large-cap funds don’t cover.

Higher Returns Compared to Large-Cap & Mid-Cap Funds

• Historically, small-cap funds have delivered higher CAGR (Compounded Annual Growth Rate) than large-cap or mid-cap funds.
• The ability of small companies to grow rapidly leads to higher capital appreciation.

Beating Inflation Over the Long Term

• Due to their high growth potential, small-cap funds can generate inflation-beating returns over time.
• If held for 5+ years, the returns from small-cap funds can outpace inflation and offer higher wealth accumulation.

Ideal for Aggressive & Long-Term Investors

• Small-cap funds are suited for high-risk, high-reward investors willing to stay invested for a long period.
• Since small-cap stocks fluctuate more, investors who stay invested for 7–10 years tend to see better gains.

Systematic Investment Plan (SIP) Advantage

• SIPs in small-cap funds help investors manage market volatility by averaging out purchase costs.
• Investing through SIP allows gradual exposure to small-cap companies rather than lump-sum investment risks.

Attractive Valuations & Lower Institutional Holding

• Small-cap stocks are often undervalued, presenting investment opportunities for long-term investors.
• Since institutional investors (FIIs, DIIs) don’t invest heavily in small-cap stocks, they aren’t overbought, leading to better entry prices.

Risks of Investing in Small Cap Mutual Fund

While small-cap mutual funds offer high growth potential, they come with significant risks and challenges. Investors should carefully evaluate these disadvantages before investing.

High Volatility & Market Fluctuations

• Small-cap funds experience sharp price swings, making them high-risk investments.
• They tend to fall more during market downturns compared to large-cap or mid-cap funds.
• Example: In the COVID-19 crash (March 2020), small-cap funds fell more than 50%, whereas large-cap funds dropped by about 30%.

Liquidity Risk (Hard to Buy/Sell Stocks)

• Small-cap stocks have low trading volumes, making them difficult to sell during market stress.
• Fund managers may struggle to exit positions quickly, leading to higher price fluctuations.
• Example: If a small-cap stock does not have enough buyers, selling it at the desired price can be challenging.

Longer Investment Horizon Required

• Small-cap funds take time to grow and may underperform in the short term.
• Investors need to stay invested for at least 5-10 years to see meaningful returns.

Underperformance in Bear Markets

• Small-cap stocks tend to decline more in recession or market corrections.
• Large investors and institutions exit small-cap stocks first, increasing the downward pressure.
• Example: During a market crash, small-cap funds often drop faster and deeper than large-cap funds.

Higher Expense Ratios & Costs

• Small-cap mutual funds generally have higher expense ratios (1.5% - 2.5%) than large-cap funds.
• These higher costs can reduce net returns, especially during periods of low performance.

Heavily Depends on the Fund Manager

• Small-cap investing requires active management and strong stock-picking skills.
• Poor fund management can lead to lower returns or heavy losses.
• Example: A weak fund manager may invest in the wrong small-cap stocks, leading to underperformance.

Frequent Portfolio Turnover & Tax Implications

• Small-cap funds frequently change their holdings, leading to higher portfolio turnover.
• This results in higher transaction costs and tax liabilities for investors.

Not Suitable for Conservative Investors

• Investors with low-risk tolerance may find small-cap funds too unpredictable and stressful.
• Large price swings can lead to panic selling, reducing potential gains.

Steps to Invest in Small Cap Fund

Step 1: Choose a top-performing small-cap fund based on past returns, AUM, and fund manager performance.

Step 2: Decide whether to invest via SIP (Systematic Investment Plan) or Lump Sum.

Step 3: Open an account with a mutual fund platform (e.g., Groww, Zerodha Coin, Paytm Money).

Step 4: Complete KYC verification (PAN, Aadhaar, Bank Details).

Step 5: Start investing and monitor performance regularly.

Pro Tip: Investing via SIP helps reduce risk and take advantage of market corrections.

Conclusion

Small-cap mutual funds offer high-reward opportunities but come with significant risks. They are ideal for risk-tolerant investors seeking high growth potential. By investing in emerging businesses, they offer the chance for multi-bagger returns. However, investors must be prepared for volatility and maintain a long-term outlook.

A Quick Quiz to Test Yourself Now!

Frequently Asked Questions (FAQs)

1. Are small-cap funds safe?

Small-cap funds come with higher risks due to market volatility. They are best suited for long-term investors who can handle fluctuations.

2. How long should I stay invested in small-cap funds?

A minimum of 5 years is recommended for small-cap funds to ride out market fluctuations and maximize returns.

3. Can small-cap funds turn into multi-bagger investments?

Yes, historically, many small-cap stocks have grown into large-cap companies, generating multi-bagger returns for early investors.

4. Which is better: A small-cap fund or a mid-cap Fund?

Small-cap funds have higher risk and higher return potential, while mid-cap funds offer a balance of growth and stability. Your choice depends on your risk appetite.

5. Should I invest in small-cap funds through SIP or lump sum?

SIP (Systematic Investment Plan) is better as it helps reduce risk by averaging out investment costs over time.

Suggested reads:

• Understanding the Upper Circuit and Lower Circuit in Stock Market
• What Are Blue Chip Stocks? Definition, Characteristics, and Examples
• Stock Market Vs Share Market: Key Differences Explained in Detail
• Types of Stocks: Importance, Benefits & Beginner’s Guide to Investing
• What Is Stock Market And How It Works? A Comprehensive Explanation