A Guide to Choosing Small-Cap Mutual Funds for Investors

Being at a young age is a time in your life when you face diverse situations; you may want to go on that dream vacation you have been saving for, or perhaps you want to buy your own first home.

But, what about your investments? When it comes to investing in small-cap funds, this article will uncover small-cap funds and how you may select a suitable small-cap mutual fund.

What Are Small Cap Mutual Funds?

Small- Cap mutual funds invest in stocks of small-cap companies, which are ranked from 251st position and onwards based on their market capitalisation. Typically, small-cap companies have higher chances of yielding better returns and outperforming the market indices, as they are in a growth and development stage.

However, it’s also essential to note that small-cap funds also have a higher inherent risk than mid-cap and large-cap mutual funds.

How Do Small Cap Mutual Funds Work?

When you select a small-cap mutual fund for you and start investing in it, your money is invested in all the small-cap companies chosen by the fund managers as per their expertise. You can see all the invested companies of the mutual fund you select, on the Asset Management Company’s website.

Also, small-cap funds should allocate at least 65% of their investment in small-cap companies as per the Securities and Exchange Board of India (SEBI) guidelines.

Advantages of Investing in Small Cap Funds

High Risk - High Returns Potential

Small-cap companies have the advantage of growth potential and innovation because as the company grows, their market capitalisation also grows, and they have the potential become mid-cap or large-cap companies in the future.

Diversification

Fund managers do the stock selection in small-cap companies with years of experience in the industry. They select stocks based on the investment objective of the scheme. They invest in companies with a diversified business model, future growth potential, and a calculated risk potential.

Undervalued Stocks

Large-cap companies are typically more in the limelight because they are reputed and grown. However, in many cases, small-cap companies can be undervalued. Despite having a robust business model, they may not get the attention they deserve.

But in the long term, small-cap stocks can be multi-baggers. Small-cap mutual funds can have undervalued stocks in their basket.

Cons of Small Cap Mutual Funds

Before investing in small-cap mutual funds, you should be aware of the risks associated with them:

Highly Volatility

Small-cap mutual funds are volatile. Small cap stock prices fluctuate more compared to large-cap stocks. If you are a risk-averse investor, small-cap funds may not be the right fit for you.

Low Liquidity

The participation of institutional and retail investors is comparatively lower in small-cap stocks, which makes these funds less liquid and may create issues in buying or selling the stocks in the market.

Depends on Multiple Factors

The performance of small-cap funds depends on multiple factors, such as the selection of stocks, the performance of the underlying stocks, and fund managers’ expertise.

Less Analyst Coverage

Typically, analyst coverage focuses more on large-cap mutual funds, while small-cap stocks may be sidelined. In many cases, small-cap companies do not have much information available, sometimes making it difficult for fund managers to select the right stocks.

Not Ideal for Short-Term Investing

If you want to park your savings for the short term, small-cap mutual funds are not ideal for you because they are volatile and may not perform as expected.

Invests in Small Companies

Small-cap mutual funds invest in small-cap stocks. Their performance may face hard times in policy changes, recessions, and more factors that impact their stock prices and mutual fund performance ultimately.

Things to Consider Before Investing in Small-Cap Mutual Funds

Risk Appetite

You must know your risk appetite before investing in small-cap funds because they are riskier than large-cap funds and see more fluctuations. If you can take higher risk, investing in small-cap mutual funds may be a good choice for you.

Experience of Fund Managers

Checking the expertise of fund managers plays a crucial role while investing in mutual funds because they are responsible for selecting the stocks for you. Hence, you should thoroughly check the fund manager experiences for the fund you are shortlisting. All the details of the fund managers are available on the Asset Management Company’s (AMC’s) website.

Investment Goals

If your investment goal is for the long term, small-cap stocks can yield you returns as the growth potential of small-cap stocks is higher.

Expense Ratio

The expense ratio refers to the fees charged by the Asset Management Company (AMC) to manage the fund. This may include the Asset Management Fees and Expenses of the scheme. You can compare the expense ratio of similar mutual funds offered by different AMCs and select one with a lesser expense ratio.

Historic Returns

Past returns do not guarantee future returns. You may understand the fund's performance in different market conditions.

Conclusion

Investing in small-cap funds in your thirties can be a good option to generate a good return with higher risk over the long-term. However, you also need to consider all the risk factors and evaluate the mutual fund thoroughly before investing in the best small-cap mutual funds. It’s also a good idea to diversify your portfolio across different asset classes to mitigate risk.

Happy Investing!

Frequently Asked Questions (FAQs)

Are small-cap funds suitable for beginners?

Small-cap funds have the potential to generate higher returns with High Risk, but at the same time, they include higher risk than mid-cap and large-cap funds. If you do not mind taking a higher risk and want to invest long-term, you can choose small-cap mutual funds.

Are small-cap mutual funds suitable for short-term investing?

Small-cap funds are less suited to short-term investing because small-cap stocks are more volatile and may hamper returns in the short term.

How long should I hold small-cap funds?

Small-cap mutual funds are ideal for you if you have an investment horizon of five years and above, as small-cap stocks are volatile in the short term, and small-cap funds perform better in the long term.

How can risk on small cap mutual funds be reduced?

You can diversify your mutual fund portfolio into different categories of mutual funds, such as investing some amount in large-cap mutual funds and some in debt mutual funds that give you stable returns and keep your portfolio balanced.

How can I select a best small-cap fund for myself?

You may check the past performance, fund manager’s experience, expense ratio, exit load, and other factors. It is also crucial to compare these factors with similar mutual funds of different AMCs before selecting best small-cap mutual fund.

Above article is authored by Quantum.

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