What are Small-Cap Funds? Mid-Cap vs Small-Cap Funds?

Small cap funds are funds that invest in the stocks of small market capitalization companies. Small cap stocks are usually riskier than large cap stocks or mid cap stocks. But they may also have higher potential for returns. Small cap stocks usually have lesser liquidity too.

What are Small-Cap Funds?

Small-cap funds are a category of equity mutual funds that allocate at least 65% of their total assets to the equity or equity-related securities of small-cap companies. According to the Securities and Exchange Board of India (SEBI), small-cap companies are those that are ranked 250th or below in terms of market capitalisation.

To put it in perspective, these companies often have a market cap of less than ₹5,000 crores. While these businesses may be small in size, they hold the potential to grow exponentially over time. However, due to their size and scale, investments in small-cap funds are inherently riskier and more volatile compared to mid-cap and large-cap funds.

How Does a Small-Cap Fund Work?

Professional fund managers actively manage small-cap funds and carefully curate portfolios of small cap stocks with significant growth potential. These managers conduct extensive research to identify small-cap companies poised for expansion or whose stock may be undervalued by the market.

When you invest in a small-cap fund, your money is pooled with other investors’ funds and used to purchase shares of small-cap companies. As these companies grow, their share prices rise, leading to an increase in the Net Asset Value (NAV) of the fund. This rise in NAV represents the returns on your investment.

For instance, suppose a fund manager invests ₹1 crore in Company X, a small-cap company manufacturing innovative eco-friendly products. As the demand for such products increases, Company X’s revenue and market capitalisation grow, leading to a higher valuation. Consequently, the small-cap fund benefits from this growth.

Features of Small-Cap Funds

Small-cap funds come with unique features that set them apart from other mutual fund categories:

• High Growth Potential: Small-cap companies are often in their growth stages, making them ideal for investors seeking substantial returns over the long term.
• High Risk and Volatility: These funds are highly sensitive to market fluctuations and economic conditions.
• Low NAV: Their Net Asset Value (NAV) is often low, allowing investors to buy more units and benefit from future growth.
• Long Investment Horizon: A time horizon of at least 7-10 years is recommended to mitigate short-term volatility and maximise small-cap fund returns.
• Diversification: Small-cap funds invest across a wide range of industries, reducing the risk associated with sector-specific downturns.

Advantages of Investing in Small-Cap Funds

• Higher Return Potential: Due to their growth phase, many small-cap companies often experience rapid expansion, offering significant upside potential for investors.
• Undervalued Opportunities: Many small-cap companies are under-researched and undervalued, presenting lucrative investment opportunities.
• Portfolio Diversification: Including small-cap funds in your portfolio provides exposure to dynamic sectors and lesser-known companies.
• Opportunity to Invest Early: Small-cap funds allow you to invest in companies before they reach their peak potential, akin to finding hidden gems.

How to Invest in Small-Cap Funds

Investing in small-cap funds is a straightforward process:

• KYC Compliance: Complete your Know Your Customer (KYC) formalities through an online or offline process.
• Choose a Platform: You can invest directly through the fund house’s website or via third-party platforms.
• Select a Fund: Research and choose a fund that aligns with your risk tolerance and investment goals.
• Invest via SIP or Lump Sum: Decide whether to invest systematically through a Systematic Investment Plan (SIP) or make a one-time lump sum investment.

Things Investors Should Consider Before Investing in Small-Cap Funds

• Risk Appetite: Assess your ability to handle volatility and potential losses.
• Investment Goals: Ensure your goals align with the long-term nature of small-cap funds.
• Fund Manager’s Expertise: Evaluate the fund manager’s track record in handling small-cap investments.
• Expense Ratio: Compare the expense ratio of small-cap funds before investing, as lower ratios maximize net returns. Additionally, funds offer Direct Plans (lower expense, for self-managed investments) and Regular Plans (higher expense, with broker/advisor assistance). Choose based on your investment approach.
• Tax Implications: Understand the capital gains tax applicable to your investments.

Difference Between Mid-Cap and Small-Cap Funds?

The primary distinction lies in the size of the companies they invest in:

• Mid-Cap Funds: Invest in companies ranked 101-250 in terms of market capitalisation.
• Small-Cap Funds: Focus on companies ranked 251 and beyond.

While mid-cap funds offer a balance of growth and stability, small-cap funds prioritise growth potential but come with higher risks.

Is a Small-Cap Fund Investment Better Than a Large-Cap Fund?

Understanding the choice between small-cap and large-cap funds is like comparing the decision to invest in an emerging startup versus an established corporation. Let’s break down this comparison in detail to help you make an informed decision based on your investment goals.

Growth vs. Stability: Understanding the Trade-off

Small-Cap Funds

Think of small-cap funds as investing in smaller companies that may have significant room for growth. These funds:

• Have higher potential for dramatic value appreciation
• Show more agility in adapting to market changes
• Often operate in niche markets with less competition
• Can potentially double or triple in value during favorable market conditions

However, they also:

• Experience sharper price swings
• Are more vulnerable to economic downturns
• May Require longer investment horizons (7-10 years)
• Need higher risk tolerance from investors

Large-Cap Funds

Consider large-cap funds as investments in well-established market leaders. These funds:

• Offer more stable returns
• May Provide regular dividend income
• Have proven business models
• Show better resilience during market downturns

But they also:

• May offer limited growth potential
• Move more slowly in response to opportunities
• Might underperform in strongly bullish markets
• Have more modest return expectations

Making the Choice: It Depends On Your Profile

The decision depends on several key factors:

• Investment Horizon
  • Small-caps: May be more suitable for longer -term investors (7+ years)
  • Large-caps: Suitable for medium-term goals (3-5 years)

• Risk Tolerance
  • Small-caps: For those comfortable with significant volatility
  • Large-caps: For those preferring stability over high returns

• Investment Goals
  • Small-caps: Wealth creation and capital appreciation
  • Large-caps: Wealth creation, Capital preservation and steady returns

Remember: Neither is inherently “better” – each serves different investment objectives and risk profiles. The most effective approach often involves a balanced combination of both, aligned with your personal financial goals and risk tolerance.

Conclusion

Small-cap funds invest in companies with small market capitalization. While they carry higher risks, their potential to deliver substantial returns makes them a compelling choice for long-term investors. By carefully evaluating your risk tolerance and investment goals, you can unlock the benefits of small-cap funds and add diversity to your portfolio.