An Investor Education Initiative
Small Cap Funds
Today’s burgeoning mutual fund ecosystem offers investors a plethora of investment opportunities, from small cap mutual funds to debt funds and index funds. Mutual fund schemes follow a variety of diverse classification routes to ensure optimal asset allocation for investors. For instance, when mutual fund schemes are classified on the basis of market capitalisation, they are divided into three major categories – large cap, mid cap and small cap fund. Among these fund types, small cap fund India invests in companies which have a market capitalisation beyond the top 250 companies listed on the index. Small cap mutual funds are an excellent investment opportunity for high-risk investors keen on robust returns and stellar growth potential. This is because a small cap fund only invests in small cap companies, which are companies that are currently expanding at a strong pace.
When compared with funds investing in large cap and mid cap companies, a small cap fund in India has the potential to offer higher returns, albeit at a much higher risk. The higher risk in small cap mutual funds comes from the underlying volatility of small cap stocks – since these have less market capitalisation than their larger counterparts, they are prone to more uncertainty and instability. However, given the enormous potential for returns inherent in a small cap fund, many investors prefer to make it a component of their portfolios, with the proportion of investment varying in line with their risk appetites and return requirements. Let us understand the nitty-gritty of small cap funds in detail.
Let us now answer the question of what is a small cap fund. A small-cap fund is a type of mutual fund that only invests in the stocks of companies falling under the small-cap category, based on their free-float market capitalisation. The term free-float market capitalisation refers to the quantum of shares of a company that is freely available in the market, for trading purposes. Companies that have a free float market cap lower than that of the top 250 companies listed on indexes such as the National Stock Exchange and Bombay Stock Exchange are termed as small-cap companies and small cap funds/schemes invest their corpus in such companies.
Let us now answer the question of what is a small cap fund. A small-cap fund is a type of mutual fund that only invests in the stocks of companies falling under the small-cap category, based on their free-float market capitalisation. The term free-float market capitalisation refers to the quantum of shares of a company that is freely available in the market, for trading purposes. Companies that have a free float market cap lower than that of the top 250 companies listed on indexes such as the National Stock Exchange and Bombay Stock Exchange are termed as small-cap companies and small cap funds/schemes invest their corpus in such companies.
Small-cap funds primarily invest in smaller companies that are in the early stages of growth or have the potential for substantial growth in the future. These companies often have a greater potential for volatility and higher risk compared to larger, more established companies. However, they can also offer the possibility of higher returns as they have room for expansion and can experience rapid growth if successful.
Small cap funds are especially attractive to investors seeking long-term capital appreciation as these schemes offer optimal exposure to companies that may be undiscovered or underrepresented in the broader market, thus unlocking the potential for market-beating returns. Additionally, the relatively less coverage by research analysts of small cap stocks can present opportunities to investors for identifying undervalued companies and yielding higher returns in the future once the intrinsic price of stocks is discovered.
Most small cap funds are actively managed, with experienced fund managers conducting thorough research and analysis to select investments. These funds invest in small cap companies exhibiting strong growth prospects, solid management teams, and competitive advantages within their industries, making it a superlative choice for mid to long-term investors keen on high returns. However, they do have various risks associated with them, owing to their smaller stature, including higher volatility and low liquidity. Therefore, small cap funds are not advisable for investors looking for short-term investment options.
Given the risk inherent in small cap funds, it is advisable to make it a smaller part of your portfolio, while offsetting the underlying risk with investments in large cap stocks, fixed income, and gold. Such a strategy enables investors to benefit from the high returns offered by small cap stocks, while also managing the risk in an effective manner. If you have a longer time horizon and a higher appetite for risk, you can make small cap funds a larger part of your portfolio but it should always be paired with safer assets, for an optimal outcome.
Now that you have a good idea of what small cap mutual funds are, let us look at how a small cap fund works. According to the guidelines put forth by the Securities and Exchange Board of India, which regulates mutual fund schemes, small cap mutual funds are required to invest a minimum of 65% of their corpus in the stocks of companies which fall within the small cap category. With regards to the benchmarks National Stock Exchange and Bombay Stock Exchange, small cap companies are those listed companies whose market capitalisation falls below the market cap of the top 250 companies listed on the indexes.
Now that you have a good idea of what small cap mutual funds are, let us look at how a small cap fund works. According to the guidelines put forth by the Securities and Exchange Board of India, which regulates mutual fund schemes, small cap mutual funds are required to invest a minimum of 65% of their corpus in the stocks of companies which fall within the small cap category. With regards to the benchmarks National Stock Exchange and Bombay Stock Exchange, small cap companies are those listed companies whose market capitalisation falls below the market cap of the top 250 companies listed on the indexes.
With a major portion of their corpus invested in smaller companies with a high growth and return potential, small cap funds work in a manner which offers comparatively higher returns to high-risk investors. Based on the market condition, such funds may even invest almost their entire corpus in small cap companies, which are riskier in nature than large and mid-caps, and therefore, it is imperative that an experienced and insightful fund manager helm such funds. Otherwise, such schemes can end up losing a large amount of their investors’ money.
Further, given the risky nature of small cap funds, investors are advised to allocate only a portion of their portfolio to these schemes, in an attempt to minimise risk and optimise returns. Making small cap funds a part of your portfolio will enable you to draw on their firepower when it comes to robust returns, while also ensuring suitable diversification. However, it is equally important to offset their risky nature by way of more stable investments in either large cap funds or debt funds. Please note that these schemes perform better in a long-term scenario, as they then receive adequate time to overcome market volatilities.
Investing in small cap mutual funds in India offers several advantages for investors looking to diversify their portfolios and potentially earn higher returns. Here are some key advantages of investing in small cap fund in India:
Strong potential for growth: small cap companies in India have the potential for substantial growth as they are in the early stages of their development. These companies often operate in niche markets or emerging industries, which can provide them with significant growth opportunities. By investing in small cap mutual funds, investors can gain exposure to these companies and benefit from their growth trajectory if they succeed.
Undervalued opportunities: As compared to large and mid-cap stocks, small cap stocks in India are often less followed and researched by analysts and the relative lack of attention can result in mispricing and undervaluation of these companies. Skilled fund managers of the best small cap funds in India can identify these undervalued opportunities and take advantage of them. By investing in these funds, investors can potentially benefit from the capital appreciation of undervalued small-cap stocks as they get recognised by the market.
Optimal portfolio diversification: small cap funds provide an opportunity for portfolio diversification and such investments can help investors balance their portfolios by including assets with different risk-return characteristics. Small cap stocks have lower correlation with large cap stocks and other asset classes, which means they can provide diversification benefits and reduce overall portfolio risk. By adding small cap funds to their investment mix, investors can enhance the diversification of their portfolios and potentially improve risk-adjusted returns.
Flexibility and agility: small cap companies are often more nimble and flexible compared to their larger counterparts, helping them adapt to market changes quickly while also increasing their efficiency when implementing growth strategies or capitalising on emerging trends. This agility can result in higher growth rates and better responsiveness to market dynamics.
Heightened opportunity for capitalisation: The small cap segment in the Indian market is generally considered to be less efficient compared to large-cap stocks and this aspect can be taken quite positively as it can create opportunities for skilled fund managers to identify mispriced securities and generate alpha. The ability of fund managers to capitalise on these market inefficiencies can potentially lead to outperformance and higher returns for investors in small cap funds.
Long-term wealth creation: Investing in small cap funds in India can be suitable for long-term investors who have a higher risk tolerance and a longer investment horizon. While small cap stocks can be more volatile and carry higher risks, they also have the potential for substantial growth over the long term. By staying invested in well-managed small cap funds and adopting a long-term perspective, investors can potentially benefit from compounding returns and generate significant wealth over time.
Now that you know the manifold advantages of investing in small cap stocks, you can start your small cap fund investment journey by carefully assessing your risk appetite, investment goals, and time horizon. Conducting thorough research, consulting with financial advisors, and selecting reputable fund managers are crucial steps in making informed investment decisions.
Small cap mutual funds can be a suitable investment option for certain types of investors who have specific investment goals, risk tolerance, and time horizons. While a small cap funds offers strong potential for higher returns, it also carries greater volatility and risk compared to larger, more established companies. Investing in small cap funds is advisable for the following types of investors –
Aggressive growth investors
Investors seeking high-growth opportunities and willing to take on higher...
Investors seeking high-growth opportunities and willing to take on higher risk may find small cap mutual funds appealing. Such investors have a long-term investment horizon and are willing to tolerate short-term volatility in exchange for potentially higher returns. They understand that small cap funds have the potential for substantial growth and are willing to invest in them to capture that growth.
Experienced
investors
Small cap funds require a level of expertise and understanding of market...
Small cap funds require a level of expertise and understanding of market dynamics. Experienced investors who have a deep understanding of the investment landscape, financial analysis, and market trends may be well-suited for investing in small-cap funds as they have the experience and temperament necessary to weather high risk and volatile situations.
Long-term
investors
Small cap funds are also suitable for long-term investors who can ride...
Small cap funds are also suitable for long-term investors who can ride out short-term market fluctuations. Small-cap stocks may experience higher volatility compared to large-cap stocks, but they also have the potential for significant long-term growth. Investors with a long-term perspective can stay invested in small-cap funds, allowing their investments to potentially compound over time.
Investors seeking diversification
Small cap funds can offer diversification benefits to investors who have...
Small cap funds can offer diversification benefits to investors who have a portfolio dominated by large-cap stocks or other asset classes. Small cap stocks tend to have lower correlation with large-cap stocks, which means their performance may not move in sync. By adding small-cap funds to their investment mix, investors can achieve a more diversified portfolio, reducing overall risk and potentially enhancing returns.
Investors with a focus on emerging sectors
Small cap companies often operate in emerging sectors and industries...
Small cap companies often operate in emerging sectors and industries with high growth potential. Investors with a specific interest in these sectors, such as technology, healthcare, renewable energy, or consumer goods, may find small-cap funds attractive. By investing in small cap funds, they can gain exposure to companies driving innovation and disruption in these sectors.
If you are wondering how to invest in small cap mutual funds, you can start the process by first assessing your personal investment profile, which includes aspects such as your risk appetite, return requirements, time horizon and investment goals. Once you arrive at your profile, you can assess its alignment with the attributes which make investors successful in the small cap fund domain. If you find that your profile matches the requirements, you can then peruse the best small cap funds available in India and pick the ones most suited to your profile. When considering how to invest in small cap funds, you should look at aspects such as the AMC’s reputation, fund manager’s expertise and expense ratio, as these factors will help you arrive at the best option for your needs.
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