Small cap Funds

When selecting a mutual fund scheme, one of the things that you need to consider while investing is the market capitalisation of the companies. You can choose between three categories of equities, viz., large, mid, and small-cap mutual funds.


These funds invest largely in companies that are relatively young, having a market capitalisation of less than ₹5,000 Crores and looking to expand aggressively. These mutual funds have at least 65% allocation of funds towards such small-cap companies.


From December 2021, when small-cap funds’ rates were at their peak, their valuation has now corrected and witnessed a fresh rallying in the recent past. 

During this period, these small-cap funds have outperformed mid and large-cap funds both in terms of response and returns. But before investing in small-cap mutual funds, you need to know some of its key features and benefits.

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Features of Small-cap Mutual Funds

As mentioned above, such stocks primarily invest in companies that are in the nascent stage of their development. The Securities and Exchange Board of India (SEBI) has mandated that any such bundle of securities must include at least 65% of small-cap stocks.


Not that these stocks offer a high potential of earning you higher. However, they are generally more volatile when compared to the other types of mutual funds. 


The following are some other key features that you must know before investing in small-cap funds:


  • Since these are fairly new companies, they have more space to expand their business and grow, and subsequently, provide higher returns

  • In the long term, these funds may provide higher returns as small companies generally require a longer period to establish a foothold and generate higher revenue

  • However, in situations of economic downturns, such smaller companies do not possess enough resources to sail through it and hence, are much more volatile  

  • One of the major issues with these funds is the availability of the number or volume of small-cap securities required by the funds

  • Small-cap companies are generally focused on a single line of business and have little diversification in their ‘core business’ 

  • Short-term capital gains (STCG), i.e., returns earned from small-cap funds in a period of up to a year, are taxed at 15%

  • Any returns of over ₹1 Lakh earned from holding a small-cap fund are considered long-term capital gain (LTCG) and are taxed at 10%

  • Any LTCG amount of up to ₹1 Lakh on an equity-oriented scheme, including small-cap mutual funds, is tax-free

Benefits of Investing in Small-cap Equity Mutual Funds

By investing in a small-cap mutual fund, you can enjoy the following benefits. 


  • Higher Growth Potential


As mentioned above, smaller companies have a higher potential to achieve speedy growth and hence, provide higher returns as compared to large-cap funds. In the past, many small-cap companies have taken a huge leap to become mid-cap and large-cap companies.


If you tap into such companies at their early stage of development, you can earn unprecedented rates of returns on your small-cap mutual funds. In short, these funds are meant for wealth creation in the long term.


  • Organic Pricing


Since large institutional investors generally avoid these equities, there is a high possibility that the price movement of these funds would be organic.


  • Diversification 


If your investment portfolio is dominated by large-cap and index securities, you can opt for these funds to diversify it. What makes small-cap funds best for diversification is that they are somewhat inversely related to index equities.  


The inclusion of these funds in the investment portfolio does not just diversify it but also balances your returns. For instance, if your returns in long-cap investment dwindle, higher returns from small-scale funds can strike a balance between the two.   


  • Long-Term Investment Tenor


Small-cap investment avenue is best for those investors who wish to hold their funds for the long-term, i.e., a tenor ranging between 5 to 7 years. This is because smaller companies generally require longer periods to expand their business and pay off higher returns to their shareholders. 


Hence, staying invested in a small-cap mutual fund may provide you with higher returns. 


  • Low Net Asset Value 


These mutual funds generally have lower net asset value (NAV), i.e., the average price of equities in this fund, as compared to mid- and large-cap funds. This allows you to purchase a higher volume of units and considerably impacts your returns.


Key Parameters to Consider When Investing in Small-cap

To choose the best small-cap mutual fund for you, you need to weigh your investment possibility on certain factors, which include the following:


  • Risk Appetite


These funds may not be the best option for you if you prefer a rather stable and less volatile investment option. You can also research different small-cap mutual funds to find one that involves the least amount of risk in this segment.  


  • Investment Tenor


These funds require you to hold your money for a longer period of time that may extend up to 7 to 10 years. So, it is advisable to consider how long you can stay invested in these funds before putting your money in these funds.  


  • Potential Returns


Small-cap funds are best for you if you wish to enjoy a higher yield by investing your money for a longer period of time. 


  • Financial Goals


If your financial goals require these funds after 5 to years, you can consider investing in small-cap funds in order to gain higher returns.


  • Taxation


As mentioned above, capital gains earned through your investment in small-cap mutual funds are taxed as STCG and LTCG. 


In conclusion, you can opt for small-cap mutual funds in order to diversify and balance your investment portfolio dominated by mid- and large-cap funds. Although these allow you to earn higher returns than the other mutual fund type, they have a high risk to them.  


By investing in these funds for a long-term period ranging from 5 to 7 years, you can provide these small companies enough time to grow into mid or large-cap companies.

FAQs on Small-cap Mutual Funds

Who can invest in small-cap funds?

Any investor with a higher risk appetite can invest in small-cap mutual funds to earn optimal returns over a longer period.

Are there any risks associated with small-cap mutual funds?

What are some of the best small-cap mutual funds in India?

Is Dividend Distribution Tax (DDT) applicable to small-cap mutual funds?


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