Embarking on the path to potential wealth creation often begins with picking the mutual funds suitable for your unique situation and objectives. But before you choose an investment instrument, it is perhaps even more important to understand the relationship between risk and return potential.
Small cap funds, which invest in companies that are often in the early stages of their potential growth journey, generally offer higher long-term return potential compared to large cap and mid cap funds. However, this relatively enhanced return potential is also associated with a higher investment risk.
In this guide, we’ll explore how to choose a small-cap fund suited to your needs by breaking down key concepts and demystifying jargon. We’ll also tie each insight back to the broader role of mutual funds, helping you see how small cap allocations can fit within a diversified portfolio and potentially help you meet your long-term financial goals.
Understanding what qualifies as a small cap mutual fund
A small cap mutual fund directs at least 65% of its assets into companies whose market capitalisations fall outside the top 250 companies by size, as per SEBI classification. These funds are governed by norms on diversification and portfolio concentration to limit excessive volatility. Within the remaining allocation, small cap fund managers may hold mid or large cap stocks or cash equivalents to potentially buffer sharp swings.
Why long-term mutual fund investments may favour small caps
Small cap companies are often in their expansion phase. If the business succeeds, the funds invested in these companies harbour the potential to deliver outsized gains, especially when market cycles turn favourable.
However, since the companies are smaller and less established, these funds can also potentially experience deeper drawdowns during corrections over the short to mid-term.
Thus, a key consideration of investing in small cap funds is a long horizon. By committing to long-term mutual fund investments, you give these businesses time to potentially realise growth catalysts and smooth over interim volatility. Over longer time periods, small cap funds have the potential to outperform large cap funds during bull phases, underscoring the importance of patience and disciplined holding.
Key criteria to review before picking a small cap fund
Before investing in small cap funds, it is important to consider various parameters. Here are some of them:
- Fund objective and strategy: Confirm whether the fund’s stated mandate aligns with your wealth goals and risk appetite.
- Expense ratio: Every basis point matters, especially over a long horizon. Aim for a lower expense ratio to ensure you retain more of your potential returns. However, do not make a lower expense ratio the sole criteria while choosing a small cap fund.
- Diversification: A well-diversified sector allocation across different industries can help to mitigate concentration risk. This approach can potentially cushion and offset the impact of potential poor performance in any one sector.
Read Also: Small Cap Funds in Bull Markets: Performance, Risks & Strategy
Important performance metrics to monitor
Quantitative measures offer comparison standards:
- Past Performance: Look at 3, 5 and 10-year compounded growth. A small cap fund performing consistently is generally preferable.
- Rolling returns: This metric displays returns across overlapping periods to highlight consistency, not just standout years.
- Alpha and beta: Alpha is a metric that measures a fund’s excess returns compared to a benchmark index. Whereas beta measures a fund’s volatility with respect to the market. An alpha above zero means the fund performance beat its benchmark. A beta above one signals greater volatility relative to the market.
- Sharpe ratio: Measures an investment’s performance relative to the level of risk taken. It indicates how much excess return is generated for each unit of risk. Sharpe Ratio above one suggests that the returns adequately compensate for the risks taken.
Regularly reviewing these metrics can help to distinguish consistent performance from sporadic outperformance.
Evaluating the fund manager’s track record
A seasoned fund manager and their decision-making can have an impact on the fund’s performance.
- Tenure: Prefer managers with a longer tenure handling small cap portfolios through multiple market cycles.
- Consistency: Review performance in bull and bear phases. Steady performers often mitigate risk and deliver potential stability of wealth.
- Research depth: Managers with on-ground analyst networks can unearth under-the-radar opportunities that may potentially enhance long-term returns.
A proven track record suggests the manager has the ability and experience to navigate the unpredictable small cap terrain, potentially delivering value beyond index returns.
Read Also: Difference Between Large Cap, Mid Cap, and Small Cap Funds
Matching your risk appetite with small cap investing
Small cap funds in India carry extremely high risk and can be rather volatile during market corrections––far more than their large cap and mid cap peers––especially over the short to mid term. Thus, they may be considered by investors who are willing to:
- Endure potentially deep drawdowns without panicking.
- Believe in long horizon investing to potentially capture growth cycles.
- Seek higher potential gains at the cost of increased volatility.
Another approach is to blend small cap allocations with large cap or hybrid funds, which are relatively more stable. This strategy can potentially smooth out interim volatility while retaining long-term growth potential.
Tax treatment when you invest in small cap funds
Small cap mutual funds are treated as equity funds for taxation purposes:
- Short-term capital gains (STCG): Gains arising from sale of units held for 12 months or lower are taxed at 20%.
- Long-term capital gains (LTCG): Gains arising from sale of units held beyond 12 months are taxed at 12.5% (no indexation) above the Rs. 1.25 lakh exemption limit per financial year.
Getting started: How to invest in small cap funds
Follow the steps below to start investing in small cap funds:
- KYC compliance: Complete Aadhaar-PAN e-KYC on AMC portals or through registrars.
- Platform selection: Investing directly via AMC websites may result in relatively lower costs, while investing via an online broker/aggregator can provide tailored advice and comparison tools.
- Investment mode: Investors can choose between lumpsum option (market timing risks) or systematic investment plan (rupee-cost averaging that mitigates market timing risk.)
- Periodic review: Align annual reviews with goal milestones, adjusting holdings only for strategic reasons, not market noise.
By following these steps, you can learn how to invest in small cap funds in a structured manner that aligns with your overall investment framework.
Common pitfalls to steer clear of while investing in small cap funds
Investing in small cap funds can offer high growth potential but comes with very high risk. Here are some common pitfalls that are best avoided.
- Avoid chasing past winners: Selecting investment funds based solely on short-term past performance is generally not recommended, as top performers may undergo mean reversion or underperform over the long-term.
- Avoid overlooking high fees: High expense ratios can erode compounding power over longer time frames. Even a small difference in the expense ratios can compound to a potentially high value in the long run.
- Avoid single-sector bets: Excess concentration in one industry can potentially spike idiosyncratic risk.
- Avoid emotional reactions: Selling during dips crystallises losses. Instead, maintain a written investment policy to guide decisions across market cycles.
Awareness of these traps can potentially ensure that your wealth creation engine stays on track.
Conclusion
Knowing how to choose the appropriate small cap fund can introduce growth potential to your corpus. By evaluating key factors such as expense ratio, fund manager’s tenure, performance consistency, tax efficiency, and alignment with your investment style, small cap funds can potentially serve as a meaningful component of an investment strategy, provided you follow a disciplined investment approach. Consider using a wealth calculator for making your financial planning easy and remember to use small cap allocations along with a diversified mutual fund mix to mitigate volatility and potentially pursue your financial objectives with confidence.
FAQs:
What makes a small cap fund suitable for long-term investment?
Small cap schemes invest in growing businesses with the potential for expansion over a period of time. This makes these schemes suitable for investors with a long horizon.
How do I assess the risk level of a small cap mutual fund?
Review quantitative metrics such as alpha, beta and Sharpe ratio. Analyse rolling returns to spot consistency, and examine maximum drawdowns over the past years to understand worst-case scenarios.
How long might one stay invested in a small cap fund?
A recommended horizon is five to seven years or longer. This timeframe allows small businesses to realise their potential and fund managers to capture potential growth.
Can SIPs be a favourable way to invest in small cap funds?
Yes. SIPs promote disciplined investing and can be a potentially effective way to average out investment costs and manage market volatility over the long-term.
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