Small-cap mutual funds are equity-oriented and invest in small to medium companies. These companies are considered less stable compared to established companies. They are usually start-ups in the early stages of growth. SEBI has defined small-cap stocks according to market capitalisation. They rank 251 onwards among all listed companies on the stock exchange. These funds need to invest a minimum 65% of their corpus in stocks of mid-cap companies.
Now, let us look at some essential features of small-cap funds.
Risk: These funds are riskier than large and mid-cap funds. In a bear market, they may suffer heavy losses. However, these funds may offer unusually high returns in a bull market. This is because they are always looking to expand aggressively. You must have heard of multi-bagger stocks. A good fund manager would try to include such shares in the fund. Such a fund may deliver exponential returns.
Returns: We know that higher the risk, higher the return. Small-cap funds have the potential to give high yields. However, in the short term, they may experience a lot of volatility.
Investor profile: These funds are for investors, who have a high tolerance for risk. They’re ideal for aggressive investors but not for first-time investors. Also, these funds should form a small portion of your portfolio. They can give an edge in returns; however, too many of these schemes may make your overall portfolio risky.
Investment horizon: We have seen that small-cap mutual funds can be extremely volatile. In the short term, they may deliver negative returns. So, one needs to stay invested for the long run. A horizon of at least 5-7 years is recommended, and it’s also essential to choose the right fund.
Returns over a period: Small-cap funds tend to perform better during a bull market. However, they may suffer heavy losses in a bear market. It is essential to see how a fund has performed in the past. Let us say a scheme has given very high returns during a bull market. If it takes a hit during the bear market, returns will be affected. So, check past performance over the best and worst market cycles. Looking at 1-year, 3-year, and 5-year yields across market cycles also helps. What you should note here is, past returns do not guarantee future performance, but reviewing them is crucial.
The fund manager: Look for a fund manager, who has experience and also a good track record. Your fund manager should have been in the industry for at least ten years. Additionally, he or she should have been with the fund for a minimum five years. A seasoned fund manager will be in a better position to select the right stocks. He or she will also know how to place bets smartly. These funds are risky; hence, an efficient fund manager is vital.
The fund house: The fund manager plays a crucial role. But, so does the team. Identifying small-cap mutual funds for investments is not easy. It is about placing bets on small companies that are undiscovered. The fund house needs to have an experienced in-house research team. Choose one which has at least a decade’s experience.
Portfolio turnover: This is a measure of how frequently a small-cap fund sells its assets. The portfolio turnover gives you an idea of how it is managed. If the turnover is low, you can infer that the fund manager is convinced about the stocks he has bought. So, he or she is employing a buy and hold strategy. Also the fund is not incurring costs to buy and sell shares. Ideally, for these funds, portfolio turnover should be less than 30 percent.
P/E ratio: It is another factor one should consider when investing in small-cap mutual funds. P/E ratio is used to choose stocks with attractive valuations. There is no benchmark for how much this ratio should be. When investing in these funds, you may compare it with benchmark P/E multiples. The comparison gives you vital information like how expensive are the stocks the fund is holding. If a fund has costly stocks in its portfolio for some time, it may face a sharper correction. The opposite also holds if the stocks fall below their benchmark. If the P/E ratio of a fund is lower than the benchmark, it can be less volatile during a bear market. However, in isolation, P/E ratio might not be conclusive. It is just one aspect investors may consider as many small cap companies would be in high growth phase justifying higher ratios.
Small-cap mutual funds can be the darling or the villain. If you can stomach the risk, they are a good investment option.
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Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.