Small-cap funds are investment options that focus on buying stocks from smaller companies. These companies have the potential to grow into larger businesses, offering profitable returns to investors. These funds fall within the category of higher-risk, higher-return investments. Read on to understand their characteristics and strategies.
Understanding small-cap funds and their investment approach
Small-cap funds primarily belong to the equity category. They allocate a significant portion of their funds to purchasing stocks of smaller companies. The Securities and Exchange Board of India (SEBI) identifies top companies and sets rules for various fund portfolios. Small-cap stocks are typically beyond the top 250 companies listed by SEBI and may not be well-known. Fund managers seek out these smaller companies that show consistent performance, sometimes surpassing the benchmark indices and larger stocks. They invest in stocks with the potential to become bigger companies in the future, aiming to offer favourable returns to retail investors. Consequently, individuals investing in small-cap funds can potentially gain an advantage over institutional and large-cap investors by focusing on smaller businesses. In bullish markets, small-cap funds can outperform larger and medium-cap funds since smaller businesses can expand significantly.
Key characteristics
Several notable features characterize small-cap funds, including the following –
- According to SEBI rules, at least 65 per cent of the fund’s assets are invested in small-cap stocks.
- These funds have the potential for high returns due to the room for growth they provide.
- While small-cap funds can yield substantial returns, they also carry high risks. These companies lack the financial strength to navigate tough market conditions and may struggle during bearish markets, leading to high volatility.
- Over the long term, small-cap funds can generate significant returns as smaller companies take time to shine in the market.
Is investing in small-cap funds right for you?
Before making any investment decision, it is crucial to align your goals, investment duration, and risk tolerance. Consider investment options that match your plans and mutual funds suitable for your objectives. Here are some points to consider before investing in small-cap funds –
Capital growth
Opt for small-cap funds if you seek substantial capital growth. These funds focus on opportunities for growth, creating valuable assets for investors. Adding small-cap funds to your investment portfolio not only diversifies it but also provides balance. If your large-cap investments are not performing as expected, small-cap funds could potentially outperform them, thus stabilising your overall portfolio returns.
Risk tolerance
These funds are appropriate for those with a high-risk tolerance due to their vulnerability to market fluctuations. While they offer more growth potential, small-cap funds lack the stability and financial resources of larger stocks. Consequently, they exhibit significant volatility, making them unsuitable for risk-averse investors.
Long-term horizon
Small-cap funds suit retail investors with a long-term horizon of five to seven years. Small-cap stocks hold significant potential, along with aggressive growth strategies. However, realising their value in the market takes time. Thus, a longer investment duration is necessary to reap the benefits of significant capital returns.
In addition to the points mentioned above, assess the historical performance of funds and asset management companies (AMCs). Consider expense ratios, competitor fund performance, and the fund portfolio released by the AMCs. This information highlights the stocks in which the funds are invested and their proportions, helping you evaluate concentration and credit risks. Remember that fund managers take calculated risks after thorough research.
Conclusion
Small-cap funds, which focus on smaller companies’ stocks, are equity mutual funds. Fund managers invest in stocks of smaller companies with growth potential, aiming to provide strong returns. While these funds offer the potential for high returns, they are influenced by market movements and may experience NAV (net asset value) declines during bearish markets due to their smaller capitalisation. Thus, these funds are suited for high-risk investors with a long-term outlook. Consider including well-performing small-cap funds in your portfolio to diversify and potentially earn suitable returns.
