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Small cap funds are a class of equity funds that invest predominantly in companies across all market sectors with a market capitalisation in the range of Rs 10 crore and Rs 500 crore. These companies are ranked after 250 in the list of companies by market capitalisation. We have covered the following in this article:
Small cap funds are those equity funds whose portfolio is mostly constituted by equity and equity-linked securities of companies that are ranked after 250 in the list of companies by market capitalisation. The market capitalisation of the underlying companies of small cap companies is in the range of Rs 10 crore and Rs 500 crore.
Since the size of these companies is relatively small, they have a very high potential to grow. Therefore, small cap companies have the potential to provide much higher returns than mid-cap and large-cap funds. On the flip side, the risk possessed by these funds is also on the higher side. Small cap funds can be volatile at times.
The table below shows the top-performing small cap funds based on the past 3-year and 5-year returns:
Small cap funds are known for their potential to offer high returns. These funds have a higher probability of outperforming the benchmark when the markets are bullish. However, when the markets enter a slump phase, the NAV of the fund gets affected significantly. Market movements heavily influence these funds.
If you are ready to take some risk to optimise the returns on your portfolio, then you can choose to invest in small-cap funds. Investing a small portion of your portfolio in small cap funds for a long-term is an excellent means of generating good returns. Risk-averse investors may not consider these funds as they can be volatile at times.
Since small cap funds are a class of equity mutual funds, they are necessarily taxed like any other equity fund plan. The dividends offered by these funds, if any, are added to your overall income and taxed as per the income tax slab rate you fall under.
Short-term capital gains realised on selling your fund units within a holding period of one year are taxed at a rate of 15%, irrespective of your income tax slab rate. Long-term capital gains of up to Rs 1 lakh realised on redeeming your units after a holding period of one year are made tax-exempt. Any gains over this limit are taxed at 10%, and there is no benefit of indexation provided.
As mentioned earlier, small cap funds are a class of equity funds. Hence, these funds also carry the same set of risks that any other equity fund scheme comes with. These funds possess market risk, concentration risk, and volatility risk. High-risk investments come with high return potential.
You can mitigate the risks to a great extent by investing via a systematic investment plan (SIP) for a long period (say five years and more). Since these funds require a long-term investment horizon, it is suitable only if you are willing to take some risk and can stay invested for at least five years.
Small cap mutual funds are subject to market risk, and investors must weigh in various components that affect the performance of the funds. You need to consider your age, the level of risk tolerance, the objective of your investment, and your investment horizon. The following are some of the other things that you must remember before investing in small-cap funds:
Pick those small cap mutual funds that balance your portfolio. Consider investing in small-cap funds that invest in small-cap stocks across various sectors. It is wise to avoid funds that predominantly invest in a few stocks. You should also look into the frequency of the trading activity going on in the fund. Successful funds tend to have lower portfolio turnover ratios of less than 30%.
Note that when deciding on a particular mutual fund, you can’t rely only on the recent performance, regardless of how well they have performed. You must take into consideration the performance of the fund across the bullish and bearish market cycles. Find out the past five year returns and compare it with peer funds. If a fund has been consistent in all market conditions and periods, then you can go ahead with it. However, note that past performance is not indicative of future returns.
The P/E ratio will give you an idea about the underlying growth potential of the fund. It will also tell you how much your fund is overpaying for growth. Small-cap mutual funds with a P/E ratio of above 30x are considered expensive.
Do your research and pick those fund houses that have a history of beating benchmark performances in both market highs and lows. An ideal fund house should have an impeccable investment process along with the technique of managing risk, an expert research team, and excellent coverage.
Explore options that allow your small-cap fund the much-needed flexibility to hold high cash or even invest in the mid- and large cap stocks. Doing this will no doubt slower the returns on your fund as compared to the returns with the small-cap, but you will get to hold more cash.
There is no doubt that small-cap funds carry risk, but there are funds that can manage risk better than peers. Explore options and the potential of garnering good returns from various schemes with low volatility.
Historically, the best small cap mutual funds have provided exponential growth and returns. Given that these stocks are relatively less scrutinised and traded by large investors, there is also a good chance of discovering some undervalued stocks among small-cap companies for small cap funds. These funds are expected to perform well when the markets are booming. You have to stay invested for at least five years to reap excellent returns.