Understanding small cap funds: Why should you include them in your portfolio

Before understanding small cap mutual funds, it is important to grasp the concept of market capitalization. Simply put, market capitalization is the total value of a company which is traded on the stock exchange. Calculating the market capitalisation of a listed company is simple – multiply the stock price by the total number of outstanding shares.

Additionally, listed companies with a rank of 251 onwards are called small cap companies and the stocks issued by them are called small cap stocks. And by extension, small cap mutual funds are schemes that primarily invest in small cap stocks.

The key characteristic of small cap funds is their focus on smaller companies that are often in the growth phase of their business lifecycle. These funds pool money from multiple investors and are managed by professional fund managers. The fund manager's role is to select a diversified portfolio of small cap stocks based on their research and analysis.

• Table of contents

1. Benefits that small cap fund investment offer to the investors
2. Factors to consider before investing in small cap funds
3. Who should be investing in small cap equity funds?
4. Things to remember

Benefits that small cap fund investment offer to the investors

High growth potential:
Small cap stocks have the potential for substantial growth, as they are often in the early stages of development and can quickly capture market share

Diversification
Small cap funds typically invest in a broad range of small cap stocks from different sectors and industries.

Long-term investment
Small cap funds are well-suited for long-term investors who can withstand short-term market volatility. The growth potential of small cap stocks may take time to fully materialize.

Potential for better returns
Historically, small cap stocks have outperformed large-cap stocks over the long term. Investing in small cap funds may offer the potential for reasonable returns.

Factors to consider before investing in small cap funds

Risk tolerance
Small cap stocks can be volatile and carry higher risks compared to large-cap and mid-cap stocks. Assess your risk tolerance and make sure you are comfortable with the potential ups and downs associated with small cap investments.

Investment horizon
Small cap funds are more suited for long-term investors. Consider your investment horizon. In case you need access to your money in the short term, small cap funds may not be the ideal choice

Fund manager's expertise
Research the fund manager's experience and track record. An experienced manager may have a better knowledge of the unique challenges and opportunities in the small cap space.

Tax considerations
Understand the tax implications of investing in small cap funds, including potential capital gains.

Who should be investing in small cap equity funds?

Small cap equity funds cater to smaller companies with significant growth potential but also entail increased risk. While these schemes may not be most suitable for risk-averse investors, they shouldn’t be completely overlooked either. Thus, opting to steer clear of small cap funds should not be seen as a prudent approach. Doing so could mean missing out on their potential to generate reasonable returns.
Investors who possess a higher risk tolerance may find it beneficial to consider allocating a portion of their portfolio to small cap funds. Moreover, diversifying with a small cap allocation can add an element of dynamism to an investment strategy.

Things to remember

When investing in small cap equity funds, it's crucial for investors to exercise patience. Rushed decisions or impulsive redemptions can swiftly erode the gains accumulated in a portfolio. In addition, it is imperative to establish a benchmark for performance comparison. Using a benchmark provides investors with an accurate measure of how well their portfolio is performing. This benchmark acts as a yardstick against which to evaluate returns, ensuring a more informed investment strategy.

Conclusion

In essence, small cap funds are not to be dismissed lightly. They offer a unique opportunity to tap into the growth prospects of smaller companies, which can lead to potentially reasonable returns over the long term. Yet, investing in these funds require discipline and a long-term perspective. By embracing the potential of small cap funds, exercising caution, and maintaining a diversified portfolio – investors can strike a balance between risk and reward in their pursuit of financial success.

FAQs:

What are small cap funds?

Small cap funds are mutual funds that primarily invest in stocks of small-capitalization companies. These companies typically have a market capitalization below a certain threshold, making them smaller than large-cap or mid-cap companies.

What are the characteristics of small cap funds?

Small cap funds are known for their potential for high growth but also come with higher volatility. They can offer diversification benefits and exposure to smaller, less-established companies.

What are the advantages of investing in small cap funds?

Investors choose small cap funds for their growth potential and the opportunity to invest in companies that may become future market leaders. They can provide diversification and potentially higher returns

What risks should investors consider with small cap funds?

Small cap funds are riskier due to the volatility associated with smaller companies. They may be more susceptible to economic downturns, and liquidity can be an issue in some cases when the mutual funds want to exit small cap companies that are not performing well. Investors should have a long-term horizon and a tolerance for risk when investing in these funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.