How Can You Build a Diverse Portfolio With Small Cap Mutual Funds?

Building a diversified portfolio is important for any investor to spread risk, mitigate the impact of market volatility and - at the same time - capitalise on growth opportunities across the spectrum.

A suitable approach that investors can consider involves including small cap mutual funds, which provide exposure to smaller sized companies. Small cap companies tend to offer a relatively higher growth potential compared to large caps and mid caps but are also associated with more risk. By allocating a portion of your portfolio to small cap funds, which cover various sectors and industries, you can position yourself to potentially benefit from significant capital appreciation over the long term.

However, while small cap allocations may drive substantial growth over a long horizon, one must include them with other, relatively stable instruments - like debt funds, blue chip funds, large caps etc. - to optimise the portfolio’s overall risk/return profile.

• Table of contents

1. Understanding small cap mutual funds
2. Why should you consider small cap mutual funds for diversification?
3. How can you build a diverse portfolio with small cap mutual funds?
4. How can you monitor and manage your small cap mutual fund portfolio?
5. Process to build a diversified mutual fund portfolio
6. Benefits of building a diversified mutual fund portfolio

Understanding Small Cap Mutual Funds

Small cap mutual funds invest in companies that are ranked 251st and beyond based on full market capitalisation. Thus, while small cap funds focus on companies within this niche, they do offer some diversification benefits as they invest in small cap entities across different sectors and industries. However, the underlying stocks in a small cap fund are related to less established companies with high growth potential with no assurance that this potential will be realised.

Why Should You Consider Small Cap Mutual Funds for Diversification?

Small cap funds can help diversify an investor's portfolio beyond large cap and blue-chip funds. While large caps dominate the primary market indices, investing only in large caps may limit the growth potential of one’s portfolio as these funds invest in established companies that may be already past their expansion phase.

On the other hand, small cap funds invest in companies that are in their growth phase and have the potential to become large caps in the future. Moreover, investors can also diversify within the small cap segment by choosing funds that focus on different sectors and industries. Some
investment strategies for small cap funds include growth Investing, and sector specific approaches.

How Can You Build a Diverse Portfolio with Small Cap Mutual Funds?

Investors can build a well-diversified portfolio by allocating a small portion of their investment in small cap mutual funds that focus on different sectors and industries.

• Consider funds that provide exposure to evergreen sectors like healthcare, FMCG, engineering, pharmaceuticals etc. to benefit from their relative relevance across market cycles.
• Seek small cap funds that focus on emerging trends like electric vehicles, clean energy, AI, etc. to potentially benefit from their long-term growth potential.
• Invest small amounts regularly in small cap mutual fund schemes to achieve sector-level diversification within this asset class.
• Check the top 10 holdings of the fund and ensure there is minimal overlap between the portfolio holdings. This way, even if one or two sectors/stocks underperform, the overall small cap funds portfolio will remain balanced.

Regular investments can help leverage long-term wealth creation through diversification. If you want to know how to build a diversified portfolio with small cap mutual, the answer is - through judicious sector allocation.

Building a portfolio with small cap mutual funds allows investors to optimise their return potential over the long term through sector-wise allocation. However, it is crucial to acknowledge the high-risk nature of small cap fund investments. Hence, one must align the overall portfolio risk/return profile with one’s unique objectives and risk appetite. This can potentially be achieved through investments in relatively stable asset classes and instruments, such as debt funds, large cap funds, actively managed hybrid funds etc.

How Can You Monitor and Manage Your Small Cap Mutual Fund Portfolio?

There are certain key aspects an investor must monitor to manage their small cap mutual fund portfolio effectively.

• Benchmark comparison: Regular tracking of the portfolio's performance against the benchmark is important to analyze whether the funds are able to beat their indices over time.
• Monitor holdings: One should also monitor the portfolio holdings of funds periodically for any major changes.
• Liquidity management: Keeping an eye on the liquidity levels of the funds is crucial, especially during volatile periods.
• Review and rebalance: Rebalancing the portfolio every year is also advisable to align it with one's evolving risk profile and goals. It is advisable to replace any underperforming funds with better-performing ones.

Reviewing the portfolio annually with one's financial advisor can help you to make changes if needed. Active monitoring ensures the small cap mutual fund portfolio stays on track.

Process to build a diversified mutual fund portfolio

Here’s a structured approach to creating a diversified mutual fund portfolio:

Identify objectives: Are you saving for retirement, property purchase, education, or another purpose?

• Set a time horizon: Determine when the funds will be needed.
• Assess risk tolerance: Understand comfort with market fluctuations and potential losses.
• Diversify investments: Spread investments across different asset classes to reduce risk.

Major asset classes:

• Equity (stocks): High growth potential, but volatile.
• Debt (bonds): Provides relative stability and income.
• Gold: Acts as a hedge against inflation.

Determine asset allocation strategy: Longer horizons and higher risk tolerance allow for greater equity exposure.

Example allocations:

• Aggressive investors: 70% equity, 20% debt, 10% gold.
• Moderate investors: 50% equity, 40% debt, 10% gold.
• Conservative investors: 30% equity, 60% debt, 10% gold.

Select funds wisely: Look into the experience and track record of the fund manager. Analyze historical performance, but remember it's not a guarantee of future returns. Compare expense ratios to minimize costs.

Benefits of building a diversified mutual fund portfolio

Creating a diversified mutual fund portfolio offers multiple benefits. Below are key advantages:

• Risk management: Diversification across asset classes (equity, debt, gold, etc.) and sectors reduces overall portfolio volatility. Spreading investments minimizes the impact of poor-performing assets on your overall portfolio.
• Returns: Strategic allocation across sectors and asset classes can unlock growth opportunities. Different asset classes perform variably, providing a more stable return stream over time.
• Achievement of financial goals: Diversification helps create a portfolio that meets specific financial goals, such as retirement or education savings. By engaging in the growth potential of multiple asset classes, you boost your chances of reaching goals.
• Improved portfolio stability: Diversified portfolios are less affected by market swings, providing peace of mind during volatility. A diversified portfolio offers more consistent performance despite the fluctuations of individual investments.

Conclusion

Building a diversified portfolio with small cap mutual funds can empower investors to participate in the long-term growth potential of smaller companies while balancing risks through diversification. Regular monitoring and periodic rebalancing of the portfolio keep it aligned with one's risk profile and goals over time. With small investments in an appropriately diversified basket of small cap funds, investors can potentially boost returns by tapping into the upside of growth-oriented small-cap stocks, thereby enhancing wealth creation potential over the long run in a balanced manner.

FAQs:

How many small cap mutual funds should I include in my portfolio for diversification?

Most financial experts recommend holding between 3-5 small cap funds spread across different sectors for adequate diversification within this market segment.

Can small cap mutual funds help me achieve long-term financial goals?

Yes, small cap funds may help boost your returns over long periods of 10+ years as they provide exposure to growing small companies. However, there will be more volatility in the short-term.

Do small cap funds have a high expense ratio?

Actively managed funds generally have higher expense ratios than index funds. Lower expense ratios allow you to keep more of your returns instead of paying them as fees to the fund manager.

What factors should I consider before investing in small cap mutual funds?

Investing in small-cap mutual funds requires assessing risk tolerance, investment horizon, and financial goals. Research fund performance, expense ratios, and diversification while understanding market cycles and liquidity needs. Consider tax implications and consult a financial advisor for personalized guidance. A long-term perspective and thorough due diligence are essential for informed decision-making.

How do small cap mutual funds differ from large cap and mid cap funds?

Small-cap, mid-cap, and large-cap mutual funds differ in market capitalization, risk, return potential, and liquidity. Large-cap funds invest in the top 100 companies, which are well-established and have significant market share. Mid-cap funds focus on companies ranked 101 to 250, while small-cap funds target smaller, higher-risk companies. Large-cap funds offer relatively stable returns with lower risk, mid-cap funds balance growth and risk, while small-cap funds have high growth potential but greater volatility.

Is it necessary to regularly rebalance a portfolio with small cap mutual funds?

Regularly rebalancing a portfolio with small-cap mutual funds helps manage volatility, maintain risk tolerance, and optimize returns. It prevents asset allocation drift, enforces disciplined investing, and ensures diversification. Rebalancing annually or at set percentage thresholds is common, but investors should consider transaction costs, tax implications, and their overall investment strategy before adjusting allocations.

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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.