Why consider small cap funds in your investment portfolio?

Investors have varying goals – some seek modest, risk-free gains while others chase higher returns although at a greater risk. Small cap mutual funds are an option for investors seeking the latter. By investing in smaller and growing companies, small cap funds provide investors with a chance to earn returns that can potentially beat the benchmarks.

Read on to learn more about why small cap fund should be part of investment portfolio.

• Table of contents

1. What are small cap funds?
2. Why consider small cap funds?
3. Risk factors to watch out for
4. FAQ

What are small cap funds?

Small cap mutual funds primarily invest in companies that have a relatively small market capitalisation. Market capitalisation is the total market value of a company's outstanding shares. It is calculated by multiplying the number of shares by the current market price per share. As per SEBI, companies ranked 251 and beyond by full market capitalisation are small cap companies.

These are typically young, growing companies operating in specialised business segments. Small cap stocks tend to be more volatile than large caps due to higher exposure to company-specific events and economic uncertainties. Fund houses are required to invest at least 65% of their corpus in small cap stocks. This ensures proper asset allocation and risk management. Small cap investing allows participation in the growth journeys of emerging companies that have the potential to become large successful corporations over time.

Why consider small cap funds?

Potential for relatively better returns

Small cap stocks tend to offer a relatively better return potential than large caps over long periods of 10-15 years. This is because smaller companies have more scope for revenue and profit growth as their operations scale up. Successful small caps that carve a niche for themselves can potentially deliver good returns in the long-term. Small cap funds give exposure to such growth stories at an early stage and the potential upside makes them a suitable investment option.

Diversification benefits

Including small cap mutual funds in your portfolio may provide diversification across various sectors. Large caps tend to be dominated by a few heavyweight sectors like finance, oil & gas, FMCG etc. Small caps add exposure to new age sectors like technology, engineering, EVs etc. Thus, proper diversification through small cap funds can enhance overall risk-adjusted returns.

Opportunity for building wealth

Small cap stocks that are able to survive cyclical downturns through prudent management tend to grow exponentially over long periods of 10-15 years. Even small investments in such rising small caps can translate into sizable wealth over the years through the power of compounding returns. Regular investing in small cap funds through SIPs facilitates rupee cost averaging and eliminates timing risks. It allows accumulating more units during periods of market volatility. Successful small cap picks held for long have the potential to become multi-baggers and create substantial wealth over a long horizon.

Suited for long term investors

Success in small cap investing depends on patience and investing with a long-term. It takes time for smaller companies to establish themselves, stabilise operations, and deliver profitable growth. Short term performance can be volatile as these stocks are also impacted by company-specific events. However, over long periods of economic and business cycles, consistent small cap performers tend to reward investors. Therefore, small cap funds can be suitable for investors with a long-term investment horizon who can ride out interim volatility and focus on the bigger picture. Monthly SIPs can be preferable over lumpsum investments to withstand market volatility.

Risk factors to watch out for

While small cap funds offer a relatively better return potential, the risks involved also tend to be greater than large caps or diversified equity funds. Key risks include company-specific issues, illiquidity in the small cap space, higher volatility compared to other fund categories.

It is important to note that past performance is not indicative of future results. Not all small cap stocks in the portfolio may succeed over the long run. Due to these risks, small cap funds should generally not exceed 10-15% of one's total equity investment. Proper stock/sector selection and monitoring fund manager performance is even more important.

Conclusion

The above reasons explain why to include small cap fund. Including small cap mutual funds in your investment portfolio allows benefitting from the returns associated with small businesses. Backing small cap players at an early stage can significantly boost long term wealth creation. However, small cap investing demands patience and ability to handle volatility. With prudent stock selection and risk management, small cap funds deserve space in a diversified equity portfolio to enhance the overall return potential over the long run.

FAQs:

How does one select a good small cap mutual fund for investment?
There are a few factors to consider while selecting a small cap mutual fund - the performance track record of 3-5 years, consistency in delivering returns, fund manager experience in small cap investing, portfolio diversification, expense ratio and turnover ratio.

What is the minimum investment amount required for small cap funds?
Most small cap funds have a minimum investment amount of Rs. 500 to Rs. 1,000 for one-time investments. For SIP investments the minimum amount is generally Rs. 500 per month.

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.