Small Cap Mutual Funds

Equity mutual funds are loved by many investors as they offer higher returns and some funds within the equity segment, offer tax benefits. There are different types of equity mutual funds, with the classification depending on various parameters. One such parameter is market capitalization and one of the ways in which equity funds are classified into different types is based on the market capitalization of the companies they invest in. The different types include large-cap mutual funds, mid-cap mutual funds, small-cap mutual funds, and so on.

In this article, we will be exploring small-cap mutual funds, how they work, the benefits of investing in small-cap mutual funds, the factors that should be considered before investing in small-cap mutual funds, and so on.

Before we learn further about Mid-Cap mutual funds, we need to understand what market capitalization is. Market capitalization refers to the total number of outstanding shares of a company in the market multiplied by the current price of each share. In simpler words, it is referred to the market value of all the shares that are held by the company's shareholders.

Let's understand this better with an example. A company, named XYZ, has 20,000 outstanding shares in the market and each share of the company is priced at ₹20. Then, the market capitalization of XYZ company will be calculated as follows:

Market Capitalization = Outstanding Shares x Price Per Share

Market capitalization = 20,000 x ₹20 = ₹4,00,000

So, the market capitalization of XYZ company is ₹4,00,000.

The stock market is classified into broad categories: Large Cap, Mid-Cap, and Small Cap. In this article, we will take a deep dive into Small-Cap Mutual Funds.

According to the Securities and Exchange Board of India (SEBI) guidelines, small-cap mutual funds need to invest at least 80% of their total assets in small-cap companies. Small-cap companies are those that have been ranked below the 250th rank in terms of market capitalization. This categorization is done by SEBI. These companies have a market capitalization of lesser than ₹500 crores.

The main reason why investors choose small-cap mutual funds is to earn higher returns over the long term. Even though small-cap mutual funds are comparatively riskier and more volatile in the short to medium term, they can deliver higher returns over a long period. It is important to know that the stocks of small-cap companies have the potential to increase twofold or threefold in a short period. However, it is suggested that you should do proper research and invest based on your risk appetite, financial goals, and liabilities.

Small-cap stocks are the stocks of those publicly traded companies that have a market capitalization of lesser than ₹5,000 crores. These firms are young and looking to expand aggressively, so they are more vulnerable and volatile to losses during downtime in the stock market. In a small-cap fund, the fund manager may have exposure to stocks of small companies in the range of 65% to 90%.

Investors opt for small-cap funds when they wish to earn aggressive returns. Fund composition also plays a major role, so if you invest all your money in small-cap mutual funds, you may end up raking in a lot of losses. Hence, it is good to invest in multiple funds and have a diversified portfolio.

There are two investment modes through which an investor can invest in mutual fund schemes. They are

Lumpsum - You choose lump sum if you wish to invest one time in a mutual fund scheme. Usually, people choose this method when they receive a bonus, so they can put the money in a scheme as a one-time investment.

If you wish to know how much and how long you need to invest to achieve your goals, please check the Lumpsum Calculator, created by Koshex.

Systematic Investment Plan (SIP) - You choose SIP when you want to invest a fixed amount in a scheme at regular intervals. You can choose to invest ₹5000 every month or ₹10,000 every quarter. When the due date comes, your amount will be deducted automatically from your bank account and it will be used to purchase units of the mutual fund scheme.

If you wish to know how much you need to invest every month via SIP to achieve your goals, please check the SIP Calculator, created by Koshex.

Small-cap mutual funds are suitable for those investors who have a high-risk tolerance. If you are open to taking high risks to earn high returns, you can consider allocating a small portion of your portfolio toward small-cap mutual funds.

It is also advisable to invest in small-cap mutual funds via Systematic Investment Plans (SIPs) rather than lumpsum. The rupee cost averaging would reduce the cost of holding. Even if you have a high-risk appetite, it is not advisable to have more than 10% to 15% of exposure toward small-cap mutual funds.

There are several benefits when you invest in small-cap mutual funds. Here is a list of a few of the advantages that you can get when you invest in small-cap mutual funds.

Growth - The main advantage of investing in small-cap funds is the significant upside growth potential, which cannot be found in blue-chip companies with large market capitalization under large-cap mutual funds.

Long-Term Bet - When you allocate a small portion of your portfolio to small-cap funds and stay invested for the long term, you tend to reap higher returns, thus helping in wealth creation.

Growth In Companies - Mostly, small-cap funds do not offer dividends because smaller companies like to reinvest any profits on growing their business, unlike larger companies.

Hidden Potential - There is a possibility that these small-cap stocks are undervalued as these small-cap companies are relatively new and unknown. So, these stocks could be available at a discounted rate and by investing in these funds, you get the opportunity to invest in these possibly undervalued stocks.

Outperforms Large-Cap & Mid-Cap Mutual Funds - Small-cap mutual funds outperform large-cap and mid-cap mutual funds in a bull run, thus providing you with a big opportunity to grow your investments quickly and earn significant returns.

Diversification - Small-cap stocks offer good room for diversification in the fund’s portfolio. If there are large-cap funds in your portfolio, you can consider investing in small-cap stocks to earn significant returns.

Liquidity - Generally, small-cap mutual funds are open-ended mutual funds. So, you can withdraw your money any time you want. One thing you need to remember is that you might have to pay an exit fee if you make withdrawals one year from the investment date.

Professional Fund Management - Mutual fund schemes are managed by fund managers. On top of that, Asset Management Companies (AMCs) recruit the finest finance professionals to develop research teams. Small-cap mutual funds allow you to get the expertise of these professionals free of cost.

Low Investment Amount - You can start an SIP in a small-cap mutual fund for as low as ₹100 or ₹5000 for lump sum investments. You can start small and increase your investment later.

Let’s say you have decided to invest in small-cap mutual funds because they suit your risk appetite and investment objectives. Here are some things you should consider before investing in small-cap mutual funds.

The first thing you need to consider is the risks involved in investing in small-cap mutual funds. It's no secret that small-cap mutual funds are highly risky and volatile. Their NAV can fluctuate sharply during bear markets or during times of uncertainty. However, they can offer significant returns. Before investing in small-cap mutual funds, you should take a look at the various funds that have performed better than the Small-Cap benchmark and other small-cap mutual funds to ensure they are getting good returns that pose less risk.

As mentioned before, small-cap mutual funds tend to give you high returns and can be a great addition to your investment portfolio. If you take a little bit of risk, you can make sure that these funds give you good returns if other instruments in your portfolio don't perform up to the mark.

You should only invest in small-cap mutual funds if you have a long-term investment horizon. Since these funds are highly volatile, they might face a sharp decline in returns in a bearish market trend over a short period.

Investors must understand the costs involved in investing in mid-cap mutual funds. The expense ratio is the amount charged by fund houses for managing the fund. SEBI has marked the upper limit for this at 2.25% of the average asset under management. If a fund has a lower expense ratio, you will earn higher returns. So, it is important to choose a fund that has the lowest expense ratio.

Before investing in small-cap funds, it is important to track their performance over the last four to five years. Small-cap mutual funds are heterogenous, unlike large-cap mutual funds. If a small-cap mutual fund has delivered good returns consistently for four to five years, then you can consider investing in it.

Even though you can withdraw your investments from small-cap mutual funds anytime you want, it is a good idea to stay invested in them for a long period. Hence, only a small part of your portfolio should be allocated to small-cap mutual funds so that you don't get overexposed to small-cap risk.

Fund composition is the portfolio of the fund, which you can find in the fact sheet. Even though it is crucial to check the portfolio of any fund to invest in, it is more important in the case of small-cap funds.

Small-cap mutual funds are subject to capital gains tax and dividend tax.

When you redeem your investments from small-cap mutual funds, you will have to pay tax on capital gains. The amount of tax you need to pay depends on the holding period, which is the period for which you stayed invested in a mutual fund scheme. Below are the capital gains tax based on the holding period.

Short-Term Capital Gain (STCG) Tax

If you withdraw your investments from small-cap mutual funds within one year, you will be taxed 15% under the Short-Term Capital Gain (STCG) tax slab.

Long-Term Capital Gain (LTCG) Tax

Long-Term Capital Gain (LTCG) tax will be applicable for those who hold the investment for over one year. For example, gains up to ₹1 lakh in a financial year are tax-free but beyond that number, the gains are taxed at 10%.

All dividends received on or after April 1, 2020, will be taxable in the hands of the investors as the DDT (Dividend Distribution Tax) on dividends was withdrawn. Also, the Finance Act, of 2020, imposes a TDS (Tax Deducted At Source) on dividend distribution by mutual funds on or after April 1, 2020. The standard rate of TDS is 10% on dividend income paid more than ₹5,000 from a company or mutual fund.

Small-cap mutual funds are a good investment option if you have a high-risk appetite and want to stay invested for a long period. They can also be a great investment choice to diversify one’s portfolio if your portfolio only has debt instruments and you want to add an equity instrument to it. The important thing to remember is to not withdraw your investments in a panic when the market declines as it might not help you earn higher returns. Choose small-cap mutual funds only if you have a long investment horizon and wouldn’t require your money immediately.

We hope this article helped you understand all about small-cap mutual funds and how they can help you achieve your goals. It is important to learn how small-cap mutual funds will benefit you and what factors you should consider before investing in them.

If you wish to learn more about other types of mutual funds, including ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.

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