What are Small Cap Mutual Funds?

What are Small Cap Mutual Funds?

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Find out the features and benefits of investing in Small Cap Mutual Funds, the investment strategies, risks and more.

Key Takeaways

  • Small-cap mutual funds invest in all companies trading on the stock exchanges, except the top 250 in market capitalisation.
  • Small-cap funds are risky but can generate higher returns.
  • Good small-cap funds aim to generate decent risk-adjusted returns.
  • You can invest in a broader universe of mutual fund schemes with small-cap funds.
  • Market volatility affects the performance of small-cap funds significantly in both directions.

Introduction

One of the most popular investment options chosen by conservative and aggressive investors alike, mutual funds help you grow your money and earn inflation-adjusted returns. These funds are managed by professional fund managers, who pool together money from various investors to invest in specific schemes in tune with their investment objectives and risk appetites. The SEBI has categorised mutual funds into several different types, and small-cap mutual funds are one of the categories. Find out what is small-cap mutual fund in this article.

What Are Small-Cap Funds?

When investing in mutual funds, investors check for an essential factorit’s market capitalisation. Now, small-cap mutual funds are those that invest in all companies trading on the stock exchanges, except the top 250 companies in terms of market capitalisation. In general, investing in small-cap funds is considered risky as they are more prone to volatility in the short term. However, you can earn higher returns if you stay invested in these funds in the long term. While there is excellent potential for booking profits, you also have to account for the risks associated with small-cap mutual funds. Small-cap mutual funds are ideal for investors with aggressive risk appetites – those who do not mind braving market volatility to earn significantly higher long-term returns.

Why Invest In Small-Cap Funds?

Having explained small-cap funds meaning, let us understand the reasons why you should consider investing in them. They are as under:

  • Compared to large-cap, mid-cap and thematic funds, small-cap funds allow you to invest in a broader universe of mutual fund schemes.
  • Small-cap mutual funds help you build your wealth at a considerably faster pace, mainly if you invest in companies in new or emerging segments.
  • Since most new companies rely on offering technology-enabled products and services, such companies have a higher potential of gaining market share and investing in them can prove beneficial.
  • Returns of small-cap mutual funds are primarily affected by company-specific factors, as opposed to macro-economic factors that affect the returns of large-cap funds.
  • Small-cap funds tend to grow at a faster pace during economic recoveries, as compared to mid-cap or large-cap funds.

How To Choose The Best Small-Cap Funds?

Here are some attributes to look for while selecting small-cap funds for your investments:

  • Funds that follow a bottom-up investment approach, aiming to identify long term opportunities.
  • Funds that look for quality, scalability and stability during the stock selection process.
  • Funds that can sustain good returns on equity and capital employed.
  • The funds must offer sustainable returns but with lower volatility.
  • The funds must aim to generate decent risk-adjusted returns.
  • The funds must have a knack for identifying high growth companies that can transform into tomorrow’s market leaders.
  • Funds that follow an active investment strategy by taking aggressive and defensive postures upon identifying market opportunities.

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Things To Consider – The Risks Of Investing In Small-Cap Funds

If you choose to invest in small-cap mutual funds, consider these points before investing:

  • Small-cap funds typically react sharply to stock market fluctuations. This quality makes small-cap funds incredibly volatile, as compared to large-cap mutual funds.
  • Investing in a lump sum amount can put your capital amount at risk, especially if the market falls. Conversely, if the market peaks and your funds perform well, you stand to earn higher returns.
  • The small-cap segment has several good companies with excellent business fundamentals. However, as an investor, you should be mindful of the quantum of your exposure, as fund prices may sharply decline during the time of market correction.
  • The rise in small-cap funds is usually driven by liquidity in the market, with prominent investors putting their money in these investments. When such investors exit the market, the small-cap companies, despite being good, could also go down fast since the liquidity becomes low in most of these stocks.
  • Unlike large and mid-cap stocks with sufficient data (past performance records) for you to base your investments, small-cap funds are relatively unknown. As such, you may not find adequate historical data or much evidence of past performance that you can assess before selecting funds for investments.

Conclusion: Who Should Invest In Small-Cap Funds?

Now that you know what a small-cap fund is, you can consider investing. These funds are ideal for investors with an aggressive risk appetite. If you are comfortable investing in significantly unknown companies with higher growth potential, you can consider investing in small-cap funds. You may also consider small-cap if you do not mind staying invested for the longer term and if you can absorb short-term market volatility and corrections. Typically, it would help if you stayed invested for at least 5 to 7 years to gain maximum benefit from investing in small-cap funds.

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*Disclaimer: This article is for information only. We recommend you get in touch with your income tax advisor or CA for expert advice.

digibank offers Mutual Funds that are instant, paperless, signatureless – even transaction fee-less! What’s more? You get to choose from 250+ Mutual Funds across 15 top-performing asset management companies. So why wait? Login to digibank (app or internet banking) and start investing in a flash with instant Mutual Funds on digibank.

Read up more on Mutual Funds here.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.

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