How to Rebalance Your Portfolio with Small Cap Funds

Most portfolios can drift away from their target mix over time. For example, the prices of large cap stocks may surge, your fixed-income bucket could shrink in real terms, and suddenly you may find yourself holding an asset allocation that no longer matches your goals or risk appetite.

If your portfolio is taking much lesser risk than your appetite for it, you can consider to rebalance your portfolio with small cap funds. Done thoughtfully and in measured doses, it can be a suitable portfolio rebalancing strategy that can restore growth potential without upending overall stability.

• Table of contents

• What are small cap funds?
• Why consider small cap funds for rebalancing?
• When should you rebalance your portfolio?
• Steps to rebalance your portfolio using small cap funds
• Benefits of including small cap funds in your asset mix
• Risks and considerations before rebalancing
• Tools and tips for effective portfolio monitoring
• Common potential mistakes to avoid while rebalancing with small cap funds
• Is rebalancing with small cap funds suitable for you?

What are small cap funds?

Under SEBI’s scheme-categorisation rules, a small cap mutual fund must invest at least 65% of its equity assets in companies ranked 251 and below by market capitalisation. These firms typically operate in niche manufacturing, technology, or consumer pockets that the larger indices barely touch. Because their earnings bases are modest yet have the potential for expansion, share prices can swing quickly in both directions, amplifying both upside potential and downside risk.

The small cap segment itself has ballooned in recent years: AMFI’s January 2025 report lists 30 schemes managing roughly Rs. 3.15-lakh-crore for 2.46 crore folios. Investors can tap this space through classic actively managed funds or newer passive vehicles that track baskets such as the Nifty Smallcap 250, giving multiple access routes for portfolio rebalancing.

Why consider small cap funds for rebalancing?

Following are a few reasons as to why you can consider to rebalance your portfolio with small cap funds:

• Return potential: Long-term data suggests that India’s smallcap segment has outpaced large caps over bull cycles.
• Diversification: Exposure to sector and style varies significantly from blue-chip benchmarks, mitigating one-factor risk.
• Valuation resets: Redistribution to small caps after sharp corrections can potentially set up a portfolio for the next rally.

Read Also: How to Build a Diverse Portfolio with Small-Cap Mutual Funds

When should you rebalance your portfolio?

• Drifting of ±5% to 10% from your strategic allocations.
• Planned review - typically annual or bi-annual.
• Life-stage events like a new source of income or nearing a money goal.
• Market dislocations: Sudden rallies or drawdowns that shuffle the portfolio’s risk–reward profile.

Steps to rebalance your portfolio using small cap funds

Take the following steps to rebalance your portfolio with small cap mutual funds:

• Specify target mix: Example - 60% large caps, 20 % debt, 15% small caps, 5% gold. *Example for illustrative purposes only.
• Compute current weights through a portfolio tracker.
• Locate variances - If small caps are at 10% rather than 15%, you have a 5-point deficit. *Example for illustrative purposes only.
• Choose small cap funds for rebalancing: Check expense ratios, tracking error (in case of passive funds), and liquidity.
• Implement in stages: Divide purchases over two-to-three months to moderate timing risk.
• Document and track: Document dates, quantities, and new weights to reference in the future.

Benefits of including small cap funds in your asset mix

Risks and considerations before rebalancing

Tools and tips for effective portfolio monitoring

• AMFI website and fund fact-sheets: Review asset-allocation drift every month.
• Monitor online data: Compare category averages and tracking error.
• Automated warnings: Utilise broker or RTA applications to trigger when weights move beyond defined bands.
• Stress-test disclosures: Since recently, AMFI requires monthly stress-test figures for small cap schemes - check worst-case liquidity situations prior to topping up.

Read Also: Difference Between Large Cap, Mid Cap, and Small Cap Funds

Common potential mistakes to avoid while rebalancing with small cap funds

• All-or-nothing moves: Gradual changes minimise timing risk.
• Overlooking exit loads or tax: Returns in less than 1 year are taxed at 20%.
• Chasing recent outperformance: Historical results don't guarantee potential for the future.
• Overlooking aggregate risk budget: Check that your equity-debt ratio is still consistent with your objectives after adjustment.

Is rebalancing with small cap funds suitable for you?

• Suitable for: Investors with at least a five-to-seven-year horizon who can stomach sharp, temporary declines in pursuit of higher growth potential.
• Less suitable for: Very conservative savers prioritising potential for capital stability; they may keep small cap exposure very low or avoid it altogether.

Conclusion

Using small cap funds for rebalancing can potentially revitalise long-term return prospects and keep your asset mix aligned with strategic targets. The segment’s history of higher, but bumpier, performance means allocations should be sized prudently and monitored regularly. Combine disciplined reviews, adequate holding periods, and staggered execution to make small caps a constructive, rather than disruptive, part of your portfolio rebalancing strategy.

FAQs

What does it mean to rebalance a portfolio with small cap funds?

It means adjusting your portfolio by selling a portion of other assets and buying small cap fund units to restore the original asset allocation percentages.

How often should I rebalance my portfolio using small cap mutual funds?

Most investors check once a year; more hands-on investors might employ a 5% to 10% drift rule or bi-annual checks.

Are small cap funds suitable for conservative investors?

They are more volatile, so risk-averse investors generally keep exposure on the smaller side or avoid it altogether.

What are the risks of using small cap funds for portfolio rebalancing?

Higher price swings, liquidity constraints during sell-offs, and potential valuation compression.

Can small cap funds improve long-term portfolio performance?

Historically, yes – category averages show double-digit annualised gains over five- and ten-year windows, but only when investors ride out interim downturns.