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Are small cap focused mutual funds always more risky?

By Finserv MARKETS - Aug 26,2019
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Are small cap focused mutual funds always more risky


When you invest in mutual funds, you have the option to choose between equity mutual funds, debt funds or hybrid funds. Equity mutual funds scheme invests primarily in shares or stocks of companies. Also known as growth funds, equity mutual funds invest at least 65% of their funds into equity shares. Classified as large-cap, small-cap, mid-cap, sector-based stocks, equity mutual funds are risky because their movement and growth are dependent on stock market performance. But the risk can potentially pay off well, with the dividend getting reinvested for goals of growth.

Equity mutual funds can be either active or passive. Under the former, the fund manager actively scans the market, goes through reams of information, examines performance and hunts for the best stocks for mutual fund investments. In the latter, the fund manager builds a portfolio that mirrors a popular market index, say Sensex or Nifty Fifty. Another more prominent classification is on the basis of market capitalization i.e. how much the capital market values an entire company’s equity. There can be Large Cap, Mid Cap, Small or Micro Cap Funds.

Let’s look at this classification closely and examine the risk contained under these mutual fund investments avenues.

1. Large-cap stocks: As the name suggests, these are stocks of large companies, the well-established ones that have been around for years and have a strong market presence like TCS, Reliance, Infosys, Hindustan Unilever. Because of the longevity and expanse of their operation, these stocks are considered low risk, and information on such stocks and companies is widely available.

2. Mid-cap stocks: Mid-cap mutual funds have a market capitalization between Rs 5,000 – Rs 20,000 cr. They can bring in surprise growth, giving higher returns in the mid-term investment horizon.

3. Small-cap stocks: Small-cap stocks are at the other end of the spectrum – these are start-ups or companies in their development stage. According to AMFI data released in June, the small-cap mutual fund category saw inflows of Rs 1415.86 crore in May versus Rs 955.83 crore in April. For investors with moderate to high-risk appetite, this is appealing because they want to bet on the potential of a company to see if it grows into something huge – these remain a highly risky investment option.

But is that always the case? Are small-cap focused equity mutual funds always riskier?

Are small cap focused mutual funds always more risky

As can be seen in the above infographic, the performance of mid-cap and small-cap mutual funds shows that in bullish markets they have outperformed the large-cap segment significantly. Have a closer look at the bull market of 2014: the average return from the top five funds in the small-cap segment was 85% higher than that from large-cap funds. Similarly, in 2017, their returns were 45% higher than the large-cap segment. The out performance of the mid-cap segment over large-caps in 2014 was 56% while it was a more moderate 10% in 2017. On the flip side, in bear markets, they see a steeper fall along with greater volatility.

There is no denying that the small-cap funds come with a high risk, but if you are willing to ride out the volatility, you can consider some exposure to the up and coming innovations and sectors through mid- and small-cap funds to give a boost to your portfolio returns.

What are the caveats? In order to reap maximum benefits, small-cap investments need to be made for the longer term: the returns from small-cap mutual funds have historically been higher than large-cap mutual funds. But you need to be patient to ride out the volatility. They don’t make it easier: the significantly higher volatility makes them a difficult investment to hold as part of the core portfolio.

So what is the key to prudent investment when it comes to equity mutual funds? One word: diversification. A well-diversified mid- and small-cap portfolio reduces the risk from the failure in one or a few companies, but you need to balance this against the returns. There is a trade-off: the more safety you bring in with diversification, the lower the returns could get. You or your fund manager needs to find your investment sweet spot somewhere in the middle.

Within a matter of seconds and 2 clicks, you can invest in mutual funds at Finserv MARKETS. Setting up an account is extremely simple. All you need to do is submit your KYC documents and fill up a few details on the Finserv MARKETS website. Once you have invested too, insights on the performance of your mutual funds are made available to you, so you can track your investment’s financial journey. Additionally, Finserv MARKETS provides personalized, exclusive offers based on your risk profile and investment goals.

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