What Are Small Cap Mutual Funds?

Chances are you have seen a few mutual fund advertisements on TV. You may have even heard the terms 'small-cap funds', 'mid-cap funds', and 'large-cap funds'. These mutual funds are categorised by their market cap. Small-, mid-, or large-cap is not the size of the mutual fund. Here ‘cap’ is indicative of the size of the companies in which the mutual fund invests.

(Read more: What is a mutual fund?)

Characteristics Of Small Cap Mutual Funds

• They invest in small-cap companies. These include start-ups or small-revenue companies that are in the early stages of development.
• The companies that small-cap mutual funds invest in have a high potential for growth in the future.
• Small-cap funds are volatile in nature. This is because small-cap companies are not financially stable. They are also not as established as larger firms.
• Small-cap funds are risky. They can generate fantastic returns for investors looking for aggressive growth and who possess high risk-taking capacities.
• Small-cap funds outperform mid- and large-cap mutual funds during a bull market. A bull market is when share prices rise, which encourages buying.
• The performance of small-cap funds decreases much more than mid- and large-cap funds during a bear market. A bear market is when share prices drop, which encourages selling.

Points To Remember Before Investing In Small Cap Fund

Your risk appetite:

Small-cap mutual funds suffer from high market risk. Any changes in the market will reflect in a change in the fund’s net asset value (NAV). When the market as a whole is not performing well, small-cap funds tend to suffer. In times of market instability, smaller and less-established companies may go out of business. On the other hand, when the market is doing well, small-cap funds have a great ability to produce greater returns than other mutual fund types. If you as an investor have a high risk appetite, you can opt for small-cap funds. (Read more: What is NAV?)

Your investment returns:

Small-cap mutual funds have done well in recent years in the Indian market. If you can tolerate risk and want investments that show aggressive growth, then small-cap mutual funds are for you. These funds have the potential to give returns of over 100% in a single day.

Your investment horizon:

Small-cap funds face a significant decrease in returns when the market is on a downswing. So, to generate good returns, you should have a long-term investment horizon. This means that your investment should last for seven to 10 years. Historically speaking, small-cap mutual funds deliver higher returns when you have a long-term investment plan.

Your financial goals:

Small-cap mutual funds invest in companies that have a high potential for generating great returns. So, if your risk-appetite is large, small-cap funds may be ideal for you. It would be a good idea to have some long-term financial goals in mind when investing. Your financial goals could be saving for retirement or paying for your children’s education, and so on.

Taxation:

You earn capital gains upon redeeming units on small-cap mutual funds. Capital gains attract taxation. But the rate of taxation depends on your period of investment in the fund. This is the holding period. Capital gains earned during a holding period of up to 12 months are short-term capital gains. They attract 15% tax. Long-term capital gains are gains earned on a holding period of over 12 months. Long-term capital gains of over Rs 1 lakh have a taxation rate of 10%.

How To Reduce Risk In Small Cap Funds Investment

• Spend time researching small-cap funds. Funds with a proven record of over five years are good.
• Diversify your portfolio so that your losses are minimal when the markets are low. A healthy mix of investments will act as a buffer against a big loss. You may even get good returns in other areas of investment when small-cap funds fail to deliver profits.
• Avoid trying to time the market, as it is risky and unreliable. Predicting the market is extremely difficult. If you go wrong in your predictions, it could lead to losses.
• Don’t buy or sell in a hurry because of market gains or losses. Both short-term gains and losses in small-cap mutual funds could be temporary. Invest for the long term to overcome market instability.
• Try to go for reliable no-load mutual funds. ‘No load’ mutual funds are funds without any commission or sales charge. It may be difficult to find such funds but it is worth a shot.
• Invest in small-cap mutual funds through a systematic investment plan (SIP). It will average out the cost, thus reducing volatility. (Read more: How to start an SIP investment?)