Investing in small cap mutual funds can be a rewarding investment strategy for investors who have the appetite for higher risk. Small cap companies are younger, leaner and more nimble compared to larger, more established companies. Though investing in small caps come with higher volatility, the long term growth potential makes them worth considering for aggressive investors. This comprehensive guide will provide everything you need to know about best small cap mutual funds to make informed investment decisions.
What are Small Cap Mutual Funds?
Small cap mutual funds invest predominantly in the stocks of companies with small market capitalization, generally less than ₹5,000 crores. The market cap is calculated by multiplying the total number of outstanding shares with the current market price of the stock.
Small cap companies are in early stages of growth and have potential to grow exponentially in short period of time. However, such companies carry higher risk due to financial instability, lack of product diversification and intense competition. Small cap mutual funds provide a way for investors to tap into the growth potential of small companies while mitigating risk through diversification across multiple stocks and sectors.
Features of small cap mutual funds:
- Invest minimum 65% of assets in small cap stocks
- Provides exposure to young, emerging companies
- Holds stocks generally with market cap less than ₹5,000 crores
- Offers higher growth potential as compared to large cap funds
- Carries higher risk due to volatility of small cap stocks
- Delivers higher returns over long term of 7-10 years
- Managed by fund managers with specialized research capabilities
Why Invest in Small Cap Mutual Funds?
Here are some of the reasons why small cap mutual funds can be rewarding for investors with higher risk tolerance:
Higher Potential Returns
Small cap stocks have room for massive growth at early stage of the business. Earnings can multiply within few years as company expands operations. This leads to exponential stock price appreciation delivering higher returns compared to large caps in long term.
Diversification
Instead of investing in individual small stocks, small cap funds provide diversification across various sectors and companies. This reduces overall portfolio risk. Within the small cap universe, aggressive funds may have concentrated bets whereas balanced funds will have wider diversification.
Long Term Wealth Creation
An SIP in small cap mutual funds over long term of 7-10 years can create significant wealth. As investors remain invested through ups and downs, they are able to reap rewards when small companies evolve into larger, established players.
Benefit from India Growth Story
Small cap companies provide a way to benefit from India’s economic growth and wealth creation opportunities. Sectors like financial services, agriculture, infrastructure, manufacturing and technology have significant growth runway. Investing in small caps provides exposure to these high potential sectors.
Professional Fund Management
Small cap funds are managed by experienced fund managers with skilled research team. They conduct in-depth analysis across sectors and companies to select best opportunities. This expertise allows investors to mitigate risks.
Who Should Invest in Small Cap Mutual Funds?
Small cap mutual funds are ideal for:
- Aggressive Investors – Investors who have higher risk tolerance and investment horizon of at least 7-10 years can consider investing a portion of portfolio in small caps for higher capital appreciation
- Young Investors – Investors who are early in their career have long earning potential ahead. They can afford to take higher risks and should consider small caps to create long term wealth.
- Under-allocated Investors – Investors whose portfolio lacks adequate exposure to small caps can invest in small cap funds to diversify and enhance returns.
However, small cap funds may not be suitable for conservative investors nearing retirement or with shorter investment horizons. Such investors should stick to large cap or balanced funds aligned to their risk appetite and goals.
How Do Small Cap Mutual Funds Work?
Small cap mutual funds work just like any other equity fund with the key difference being the allocation to small cap stocks. Here is how they function:
- Funds collect money from investors through NFO or ongoing subscriptions. This forms the corpus of the fund.
- The fund manager and research team evaluate small cap stocks across sectors to identify high potential companies.
- Minimum 65% of corpus is invested in small cap stocks while remaining in mid caps and large caps for diversification.
- Fund managers actively manage the portfolio based on market conditions and company fundamentals. Stocks are bought and sold to generate returns.
- Profits booked and dividends received are passed on to investors as capital appreciation. This increases the fund NAV.
- Investors can redeem part or full investment by selling fund units back to the fund house at current NAV rates.
- Taxation applies on capital gains made on redemption or dividend paid by the fund.
Thus small cap funds provide a low cost, convenient way for investors to earn higher returns by participating in India’s high growth potential small companies.
How to Invest in Small Cap Mutual Funds?
Here are some tips for investing in small cap mutual funds:
Evaluate Your Risk Appetite
Since small caps carry higher volatility, assess your ability to tolerate risks before investing. Factor in investment horizon, financial goals and liability commitments before deciding allocation to small caps.
Choose Fund House Carefully
Stick to reputed AMCs like ICICI, HDFC, Kotak etc. with long track record in managing small cap funds. Review portfolio concentration, diversification, fund manager pedigree and performance across market cycles.
Invest for Long Term
Small caps deliver superior performance over long investment horizons of 7-10 years. So invest with willingness to remain invested through volatile periods. Avoid redeeming during market downturns.
Start SIP for Regular Investments
Systematic investment plan (SIP) allows investing a fixed amount regularly in small cap funds. This averages out cost and reduces market timing risks.
Rebalance to Book Profits
Book profits by redeeming units once small caps in your portfolio have grown significantly and allocate capital to other funds. This helps realize gains and maintain allocation.
Limit Overall Allocation
Restrict overall allocation to small caps to 10-20% of your equity portfolio. Too much exposure can lead to concentrated risks.
Staying disciplined, following asset allocation and focusing on long term goals is key to success in small cap investing.
Factors to Consider Before Investing in Small Cap Mutual Funds
While small cap funds offer higher return potential, they also carry significant risks. Assess these factors before investing:
- Market Capitalization – Check the market cap range of companies the fund invests in. Less than ₹1,000 crores market cap indicate very small, high risk companies.
- Liquidity – Small companies may suffer from lower liquidity. Verify fund’s liquidity profile.
- Valuations – Steer clear of funds investing in overvalued stocks carrying high risk.
- Diversification – Well diversified funds across sectors and companies have lower risk.
- Volatility – Small caps tend to be more volatile. Review your risk tolerance before investing.
- Fund Performance – Opt for funds with consistent long term track record in up and down markets.
- Fund Manager Experience – Prefer funds where fund manager has managed small cap funds through multiple market cycles.
- Costs – Compare expense ratio, exit load and other costs before investing.
- Asset Allocation – Limit overall allocation to small caps based on financial profile.
By carefully evaluating these parameters, you can make prudent investment decisions in small cap mutual funds.
Advantages of Investing in Small Cap Mutual Funds
Let us look at some of the key benefits of investing in small cap mutual funds:
Long Term Growth Potential
Small cap funds have demonstrated ability to deliver higher inflation adjusted returns over long investment horizons of 7-10 years.
Benefit from India’s Economic Growth
Small companies with nimble business models are best positioned to tap into India’s consumption and infrastructure growth story.
Gain Early Access to Emerging Businesses
Small caps provide early investment opportunities into companies that evolve into future blue chips.
Diversification Benefits
Adding small caps to a portfolio offers diversification and reduces correlation with large cap stocks.
Hedge Against Inflation
Small caps earnings tend to rise faster during inflation leading to higher share prices that beat inflation.
Wealth Creation for Young Investors
Younger investors with longer time horizon are best positioned to benefit from the wealth creating potential of small caps.
Active Fund Management Expertise
Specialist fund managers conduct in-depth research and evaluation to pick best opportunities.
Thus, small cap funds offer attractive growth prospects for informed investors willing to adopt a long term approach and withstand volatility.
Risks Involved in Investing in Small Cap Mutual Funds
While small caps offer higher growth potential, they also carry higher risks that must be evaluated:
Volatility Risk
Small cap stocks see wider price fluctuations compared to large caps. Their earnings are more uncertain leading to higher volatility.
Liquidity Risk
Thin trading volumes in small cap stocks can make it difficult for funds to sell holdings at desired price and time.
Financial Instability
Small companies have shorter operating track record. They may not have robust systems or business models leading to higher failure rates.
Corporate Governance Issues
Small caps tend to have weaker transparency and compliance standards leading to higher corporate governance risks.
Concentration Risk
Since small cap universe is limited, funds tend to have concentrated portfolios exposing them to company specific risks.
Riskier Sectors
Small caps are more prevalent in high risk sectors like commodities, technology which are more vulnerable to business cycles.
Macro-economic Risks
Small companies have lower financial resilience to withstand economic downturns or rising interest rate cycles.
Lack of Coverage
Limited publicly available research and information on small cap stocks makes analysis more difficult for fund managers.
Longer Waiting Period
It takes longer time frame of 7-10 years for small caps to realize their full growth potential and deliver robust returns.
By starting a SIP, adopting long term approach and following prudent diversification, investors can overcome the volatility and risks in small cap investing.
Taxation on Small Cap Mutual Funds
Here is how small cap mutual funds are taxed in India:
- Short Term Capital Gains – Profit booked on redemption before 12 months is taxed at 15%
- Long Term Capital Gains – Profit booked on redemption after 12 months is taxed at 10% beyond ₹1 lakh gains in a financial year
- Dividend Income – Dividend from small cap funds is taxable in hands of investor as per applicable tax slab
- Exit Load – Exit load if any charged by the fund reduces capital gains exemption limit
- Tax Deducted at Source – TDS is applicable on dividend income beyond ₹5,000 per financial year
Thus, taxation on small cap funds is similar to other equity funds. Long term holding period of over 1 year delivers taxation efficiency and enhances post-tax returns.
Popular Small Cap Mutual Funds
Here are some of the top rated small cap mutual funds based on consistent long term performance across market cycles:
Comparing Small Cap Mutual Funds:
| Fund | Minimum SIP | AUM (Cr.) | 3-Year Return |
|---|---|---|---|
| Quant Small Cap – Direct Growth | ₹5,000 | 13,001 | 53.1% |
| Bank of India Small Cap – Direct Growth | ₹5,000 | 845 | 47.2% |
| Canara Robeco Small Cap – Direct Growth | ₹5,000 | 9,174 | 37.0% |
| Kotak Small Cap – Direct Growth | ₹100 | 14,082 | 39.5% |
| Edelweiss Small Cap – Direct Growth | ₹100 | 3,002 | 47.6% |
| Nippon India Small Cap – Direct Growth | ₹5,000 | 43,815 | 53.3% |
| Union Small Cap – Direct Growth | ₹1,000 | 1,285 | 47.4% |
| SBI Small Cap – Direct Growth | ₹5,000 | 23,716 | 30.5% |
| Sundaram Emerging Small Cap Series VII – Dir Growth | ₹5,000 | 159 | 49.8% |
Highlights:
- Top Performers: Quant Small Cap and Nippon India Small Cap stand out with impressive 3-year returns exceeding 53%.
- Low Minimum SIP: Kotak Small Cap and Edelweiss Small Cap offer accessible entry points with minimum SIPs of ₹100.
- Large Asset Bases: Nippon India Small Cap and Kotak Small Cap boast substantial AUMs, potentially indicating investor confidence.
- Lower Performer: SBI Small Cap falls behind with a significantly lower 3-year return compared to other funds.
Investors should evaluate personal risk appetite, investment goals and asset allocation strategy before selecting any small cap mutual fund.
Conclusion
Small cap mutual funds offer young investors an avenue to participate in India’s high growth potential small companies. The funds provide access to emerging sectors and business models while mitigating risks through diversification. Volatility and liquidity risks are offset by potential to generate inflation beating returns over long term. By adopting a disciplined approach, following prudent asset allocation and avoiding market timing, investors can harness the wealth creating ability of small caps. As small companies evolve into larger players, patient investors will be rewarded for their commitment. However, small cap investing requires suitable risk tolerance and ability to withstand short term fluctuations. Through careful research and handpicking quality focused funds, investors can incorporate small caps in their portfolio for value creation.
Frequently asked questions
Are small cap funds good for new investors?
No, small cap funds are meant for experienced investors with high risk appetite and investment horizon of at least 7-10 years. New investors should start with large cap or balanced funds.
Are small cap funds suitable for short term investment?
No, small cap funds are not ideal for short term durations of less than 3 years due to their volatility. They should be held long term to realize full potential.
Are small cap funds taxable?
Yes, short term and long term capital gains from small cap funds are taxable. Dividend income is also taxable as per investor’s tax slab.
Are Small Cap Mutual Funds high risk?
Yes, small cap funds carry higher volatility and risks compared to large cap and diversified funds. They should form limited part of one’s portfolio.
Can all small cap mutual funds pay dividends?
Yes, small cap funds have the option to pay dividends subject to availability of distributable surplus. However, all funds may not pay dividends regularly.
How are small cap mutual funds taxed in India?
Small cap funds attract short term capital gains tax of 15% if redeemed before 12 months. Long term capital gains are taxed at 10% after 12 months. Dividends are taxed as per the investor’s tax slab.
How long should I stay invested in Small Cap Mutual Funds?
Ideally 7-10 years to realize the full potential. Minimum investment horizon should be 5 years to ride out volatility.
How much money should I invest in small cap funds?
Maximum 15-20% of equity portfolio can be allocated to small cap funds from asset allocation perspective.
How to choose the correct small cap funds to invest in?
Analyze long term performance across market cycles, fund manager track record, diversification, portfolio concentration and costs before selecting a small cap fund.
How to invest in small cap mutual funds online?
You can invest in small cap funds online via mutual fund investment platforms like Paytm Money, Groww, INDMoney etc by completing your KYC.
Should I invest in small cap mutual funds?
Only if you have high risk tolerance, investment horizon of 7-10 years and want to add funds with growth potential to your portfolio. Else stick to large cap and balanced funds.
What are the expected returns of small cap funds in India?
Small cap funds can generate inflation beating returns of 18-25% over long investment horizons of 7 years or more.
What are the main advantages of investing in Small Cap mutual funds?
Key advantages are high growth potential, benefit from India’s rising economy, early access to emerging companies, diversification and ability to beat inflation over long term.
What are the risks involved in investing in small cap funds?
Key risks are volatility, liquidity risk, financial instability of small companies, corporate governance issues, concentration risk and vulnerability to economic downturns.
What is Small Cap mutual fund meaning?
Small cap funds invest predominantly in stocks of companies with less than ₹5,000 crore market capitalization with higher growth potential and risks.
What is the distinction between small-cap versus mid-cap mutual funds?
Small cap funds invest in companies with market cap less than ₹5,000 crores while mid cap funds invest in companies with market cap between ₹5,000 to ₹20,000 crores.
What is the major risk of investing in a small-cap fund?
The major risks are steep volatility, lower liquidity compared to large caps, financial instability and high failure rate of small companies.
What kind of returns can I earn from Small Cap?
One can expect SIP returns of 18-25% over long term of 7-10 years from diversified small cap mutual funds.
What type of returns can be earned from small cap funds?
Small cap funds can potentially deliver 18-25% CAGR returns over investment tenures of 7-10 years, by investing in early stage companies with exponential growth prospects.
Where do Small Cap Mutual Funds invest?
Small cap funds invest minimum 65% of corpus into stocks of companies with less than ₹5,000 crore market cap from sectors like financial services, agriculture, infrastructure, manufacturing and technology.
Which are the best Small Cap Mutual Funds to invest in 2024?
Based on consistent long term performance, some of the best small cap funds are Axis Small Cap Fund, Kotak Small Cap Fund, HDFC Small Cap Fund, IDBI Small Cap Fund and ICICI Pru Small Cap Fund.
Who are small cap funds most suitable for?
Small cap funds are best suited for aggressive investors with high risk appetite and ability to invest for long tenure of 7-10 years.
Who can invest in Small Cap mutual funds?
Investors with moderately high risk tolerance looking for long term capital appreciation can consider small cap funds to diversify their portfolio, after suitable research.
Also Read: Best Mid Cap Mutual Funds to invest in 2024
