What are small cap funds

When you plant multiple saplings, some may wither away due to unfavourable weather conditions, lack of proper care, or pests. Others may receive the right amount of sunlight, water, and care and grow into healthy, strong plants. Small-cap companies are like a collection of saplings. Some may wither away due to market downturns, while others may flourish, beating market volatility. Small-cap funds are mutual funds that offer exposure to small-cap companies. But what are small-cap funds exactly, and do they make for a good investment option? Let’s find out.

What is a small-cap mutual fund?

Small-cap mutual funds are open-ended equity funds that primarily invest in stocks of smaller-sized companies, commonly known as small-cap companies. These companies typically have a market capitalisation of less than Rs 5000 crores and are ranked as the 251st company onwards in terms of full market capitalisation. Small-cap mutual funds aim to invest at least 65% of their total assets in small-cap stocks.

Small-cap companies are young players with potential. They are not yet at the top of their game in their respective industries, but they carry the scope to grow over time. Small-cap funds allow you to be a part of this growth.  

Note - Market capitalisation represents the total market value of a company's outstanding shares.

While small-cap funds can seem promising, there are some things you should know about them to arrive at a well-informed investment decision.

Things to consider before investing in small-cap funds

• Investment horizon: Small-cap funds are generally suited for long-term goals. They may be suitable if you can hold your investments for an extended period. However, they may not be suitable for short-term goals due to their higher volatility and potential for greater short-term fluctuations.
• Risk appetite:Small-cap funds invest in smaller-sized companies that are at a relatively early stage of development. This makes them riskier compared to mid- and large-cap funds. While they offer the potential for you to be a part of the company's growth, they also carry higher inherent risks. Therefore, evaluate your risk appetite carefully before investing.
• Expense ratio: All mutual fund schemes, including small-cap funds, charge investors to cover administration and management costs. Comparing the expense ratio before choosing a fund can help you enhance your overall returns.
• Tax liabilities:Small-cap funds are categorised as equity funds and are subject to long- and short-term capital gains tax. The tax rate can vary based on your holding period. Profits earned from funds that are held for up to a year are taxed at a flat 15% short-term capital gains tax rate. On the other hand, gains from funds held for more than a year are qualified as long-term capital gains and are taxed at a 10% rate on gains exceeding Rs 1 lakh in a financial year.

Who should invest in small-cap funds?

Small-cap funds are susceptible to short-term fluctuations as they invest in companies that are not as well-established yet. Hence, they may be suitable for achieving long-term financial goals, such as retirement, a child's higher education, house ownership, and other similar needs.

While all equity funds carry risk, small-cap funds may be the highest on the risk metre among funds of all market capitalisations. So, these funds may be suitable only if you have a high risk appetite.

You can also invest in them if you wish to diversify your portfolio and balance out risk and return across market capitalisations.

How to invest in small-cap funds?

The process of investing in small-cap funds is the same as any other mutual fund scheme. You can start by reaching out to an Asset Management Company (AMC) or a registered broker. To open an account, you may be asked to submit Know Your Client (KYC) documentation, such as PAN, a copy of your Aadhaar Card, etc.

Once your account is active, you have two options to invest in small-cap funds - Systematic Investment Plan (SIP) and a lump sum investment.

With SIP, you can regularly invest a fixed sum of money at periodic intervals (weekly, monthly, or quarterly). Alternatively, with lump sum investments, you can invest a single sum of money in one go.

Conclusion

Remember to keep a long-term investment horizon if you are keen to invest in small-cap funds. Also, be mindful of the risks involved and make a well-calculated decision. Apart from this, research well and ensure that no matter what you invest in, you have a well-diversified portfolio that caters to your goals.

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