Small cap fund
A small cap fund is a type of mutual fund that primarily invests significant portion of money in equity shares of small cap companies to be exact minimum 65% of funds should be invested in small cap companies. These companies are ranked 251st and below in terms of market capitalization. Small cap fund is managed by professional fund manager. Small cap funds have high risk as small cap companies are in early development stage of underlying companies and are more vulnerable to market fluctuations and economic trends at the same time it can yield higher returns than traditional investment plans.
Why invest in small Cap funds:
- Significant Growth Potential: Investments in developing businesses with strong growth and diversification possibilities.
- Undervalued Assets: Due to underestimation, investing in small businesses at lower costs may yield long-term returns as they grow.
- Mergers and Acquisitions (M&A): Small enterprises offer significant M&A opportunities, potentially leading to benefits as they merge with larger companies.
Before investing in small cap fund analyze the historical data of the fund, aum of the fund, and more importantly consider your risk profile and risk appetite, experience of fund manager, expense ratio and your financial goal.
Definition and Regulatory Classification:
Definition
- SEBI defines small-cap companies as those ranked below the 250th company in terms of full market capitalization (i.e., companies ranked 251st and onwards).
- The exact market capitalization threshold can vary, but small-cap companies are commonly characterized as those with market cap typically below Rs 5,000 crore in India.
- A Small Cap Fund must invest at least 65% of its total assets in equity or equity-related instruments of small-cap companies according to SEBI guidelines.
Regulatory Classifications:
Must invest at least 65% of their corpus in small-cap stocks. The classification of stocks is given below (SEBI (Securities and Exchange Board of India) classification):
- Large Cap: Top 1st to 100th companies by market capitalization.
- Mid Cap: 101st to 250th companies by market capitalization.
- Small Cap: All companies ranked 251st and below by market capitalization.
How does small cap fund work:
A small cap fund works by collecting money from investors and investing it primarily in the shares of small cap companies, which are those ranked 251st and below by market capitalization as determined by SEBI. Here’s how small cap funds operate, step by step:
- Portfolio Construction: The fund manager is required to invest at least 65% of the fund’s assets in equities of small cap companies. These companies typically have a market capitalization lower than ₹5,000 crore and are usually younger or in the early stages of growth.
- Stock Selection: Fund managers may use a combination of top-down (focusing on overall sector trends) and bottom-up (individual company analysis) strategies to select companies from a much wider universe compared to large and mid-cap stocks.
- Diversification: To manage risk, the portfolio is generally diversified across sectors and companies, as individual small companies can be more volatile. This diversification can help reduce concentration risk.
- Active Management: Due to the dynamic and under-researched nature of small cap stocks, most small cap funds are actively managed. Fund managers constantly monitor the market to identify high-growth, undervalued firms with the potential to become future leaders.
- Growth and Volatility: Small cap companies have the potential to deliver higher returns over the long term because they are in expansion phases. However, they also carry higher risk and volatility, as they are more sensitive to market fluctuations and economic downturns.
- Review and Rebalancing: Fund managers periodically review and rebalance the portfolio to maintain the desired allocation to small cap stocks and to respond to changing market situations.
- Small cap funds may allocate the remaining portion of the corpus to mid-cap or large-cap stocks, as well as debt or money market securities for liquidity, but will always remain predominantly small cap heavy.
Features of small cap funds:
- High Growth Potential: By investing in smaller, early-stage companies with room for expansion, these funds can deliver superior long-term returns if the chosen companies succeed.
- Higher Risk & Volatility: Small cap funds are much more volatile than large- and mid-cap funds. Share prices of small cap companies can fluctuate widely based on market conditions, making these funds suitable only for investors with a high-risk appetite.
- Long-Term Investment Horizon: Optimal gains from small cap funds ideally require remaining invested for 5–10 years, to ride out periods of volatility and capitalize on long-term growth.
- Active Management: Fund managers play a vital role by researching and identifying promising, under-the-radar companies. Their expertise is especially important in this segment, where risks are higher.
- Diversification: These funds often invest across different sectors within small caps, helping mitigate some company-specific risks.
- Minimum 65% Allocation: Regulatory guidelines mandate that small cap funds must allocate at least 65% of their assets to stocks of small cap companies (ranked below the top 250 by market capitalization).
- Potential for Exceptional Returns: When markets perform well, small cap funds have the ability to outpace returns of other fund types; during downturns, they can fall more sharply.
- Higher Expense Ratios: Due to active management and research, small cap funds usually have higher expense ratios than large-cap funds, which can slightly reduce net returns.
- Taxation: Like other equity funds, gains from small cap funds are subject to capital gains tax and, if dividends are paid, dividend distribution tax.
Pros and Cons:
Pros:
- High Growth Potential: Small cap funds invest in companies at an early growth stage, offering potential for exponential returns if these businesses succeed and expand.
- Portfolio Diversification: By including small cap funds, investors access sectors and stocks not always covered by large institutional investors, enhancing diversification.
- Under-researched Opportunities: Small cap stocks often remain overlooked by major institutions and analysts, creating opportunities for skilled fund managers to find undervalued “hidden gems”.
- Potential to Outperform in Bull Markets: Small caps can surge rapidly and often outperform large and mid-cap funds in rising markets.
Cons:
- High Volatility and Risk: Small cap funds are highly sensitive to market swings, losing value quickly during downturns and often fluctuating more than their large- and mid-cap counterparts.
- Liquidity Issues: Shares of small cap companies may have low trading volumes, making it difficult to buy or sell large quantities without affecting prices.
- Requires Long-Term Commitment: Success often demands patience and a long investment horizon (typically 7–10 years) since small companies may take years to realize their growth potential.
- Challenging to Select Winners: It is difficult to identify which small cap companies will thrive, placing heavy emphasis on fund manager expertise and research.
- Tax and Expense Considerations: High expense ratios and less favorable short-term capital gains tax can erode net returns.
- Unsuitable for Conservative Investors or Beginners: Due to high risk, these funds are best for seasoned, risk-tolerant investors rather than beginners or those seeking stable returns.
Disclaimer
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
