What are Small Cap Mutual Funds? Definition, Advantages, and Risks Explained

Small-cap companies are on a bull run, and so are small cap mutual funds. Recently, they have been in the limelight just because of their higher returns. The Nifty Small Cap 250 index, which measures the performance of small market-cap companies, gave investors a 64% return last year.

But what about the risks involved in small-cap funds & will they offer similar returns in the coming future?

In this blog, we will give you an overview of small-cap mutual funds, the advantages, the risks involved, and answers to the above-mentioned questions.

Overview

Before jumping into the explanation of small-cap funds, check out our blog on mutual funds, where we have simplified the topic: Mutual Funds: Meaning, Types, Features, Benefits and How They Work.

Based on their market capitalization, companies in India are categorized as Large, Mid and Small-Cap companies. As per SEBI, the definition of Large, Mid and Small-Cap is as follows:

1. Large Cap: 1^st -100^th companies in terms of Market Cap.
2. Mid Cap: 101^st – 250^th companies in terms of Market Cap.
3. Small Cap: 251^st company onwards in terms of Market Cap.

So, small-cap mutual funds invest in small companies. As per rules prescribed by SEBI, at least 65% of their investments are in small cap companies. Most of the small cap companies are generally new and expanding aggressively, but they are technically fragile and might lose money in a volatile market.

Small-cap mutual funds carry high-risk and are volatile in nature. The small-cap companies generally have low market float and have less trading volumes; this makes them vulnerable to adverse events and susceptible to bearish market movements. They have the potential to give higher returns in a bull market. However, they fall at a rapid pace in bearish markets.

Pros of Investing in Small-Cap Mutual Funds

• Small-cap companies have the potential to grow rapidly because of their relatively small operating scale. There’s a great saying, “Almost all multi-baggers are small cap companies once.” It allows fund managers of small cap mutual funds to reap the benefit of investing in hidden gems.
• Small-cap companies have the potential to capitalize on emerging trends, fostering a sense of agility and innovation and helping to enhance the business.
• Small-cap companies are open to pivoting their strategy and business model. It is advantageous when changing economic and technological scenarios compared to large-cap companies.

Points to Consider

So far, we have understood that small-cap mutual funds are considered high-risk in the world of mutual funds. There are a few points that you should consider before investing in small-cap mutual funds:

• Small-cap mutual funds indeed have a potential to give higher returns, but you should also consider the expense ratio of the fund before investing. As small-cap funds are actively managed, their TER, i.e., Total Expense Ratio, is generally higher than that of other mutual fund categories. Further, choose a direct route rather than regular small-cap funds.

• When the market starts falling, even the top small-cap mutual funds can see erosion in their returns. Therefore, if you are considering investing in small cap funds, invest for the long-term, preferably >5 years.
• Investors who are heavily invested in large cap companies and want to diversify their investments can look for small-cap mutual funds.
• Investment in small-Cap mutual funds is much riskier and more volatile than large-cap funds. Therefore, it is suggested for investors with a high risk appetite.

Taxation Rules

As mutual funds can be of different types, so is their taxation. However, taxation on all equity mutual funds remains the same, whether it is large, flexi, or small cap. Ignoring taxation can significantly impact your net returns post taxation.

Capital Gain Tax

For small cap funds, STCG (short term capital gain) will apply if the holding period is less than one year and LTCG (long term capital gain) if the holding period exceeds one year.

In the case of LTCG, there is no tax till the income of one lakh; post this limit, a 10% tax is applicable without indexation benefit. In case of STCG in small-cap funds, there is a flat 15% tax on gains without indexation benefit.

If you are curious to learn more about the taxation of Mutual Funds in India, check out our blog: Decoding Mutual Funds Taxation In India

Top Performing Small Cap Funds

Here are some top-performing small-cap funds based on the performance:

Key Highlights of AMFI Notice

On 27 February 2023, the Association of Mutual Funds in India (AMFI) sent a notice to All Asset Management Companies (AMCs) in India when the regulator, i.e., SEBI has raised concerns regarding the continuous flow of funds in Mid and small-cap mutual funds. The AMFI has asked fund houses to develop a policy and take appropriate measures to protect investors.

• AMFI focuses on the ability of the fund house to face redemption pressure and detect whether any funds has liquidity issue or not.
• All AMCs must disclose the outcomes of the Stress test, volatility, liquidity analysis, valuation, and portfolio turnover concerning mid-cap and small-cap equity schemes.
• Asset Management Companies will display the stress result within 15 days after the end of each month.
• AMFI emphasizes investor protection and enhanced transparency within the mutual fund industry.

Conclusion

In summation, small-cap mutual funds offer the potential for high returns and a great diversification opportunity. However, these funds come with significant risks due to the volatile nature of small-cap companies.

Investors should carefully consider the risks and other relevant factors such as expense ratio, historical returns, fund manager, etc. before investing in small-cap mutual funds. It is suggested to consult with a financial advisor before investing.

Frequently Asked Questions

1. Are small-cap funds risk-free?

Ans: No, small caps are not risk-free, in fact small cap mutual funds carry a higher risk than other category of mutual funds. It is advisable to research before investing in small-cap funds and seek help from your financial advisor.

2. What is the suitability of small-cap mutual funds?

Ans: Small-cap mutual funds are generally suitable for Investors having a high-risk appetite with a time horizon of at least 5 years.

3. What is the difference between Small-Cap and Flexi-Cap Mutual funds?

Ans: A small-cap mutual fund invest at least 65% in small cap companies. In contrast, a flexi-cap mutual fund invest at least 65% in equity & equity related instruments, which means flexi cap funds are more flexible as they can invest in large, mid or small cap companies.

4. What is a Small Cap mutual fund?

Ans: A small-cap mutual fund invest at least 65% in small-cap companies.

5. Do small-cap funds carry higher taxation?

Ans: No, small-cap funds are taxed in a similar manner to any other equity mutual funds.

Disclaimer: The securities, funds, and strategies mentioned in this blog are purely for informational purposes and are not recommendations.