Small Cap Etfs: Meaning, Benefits and Who May Consider Investing

India’s expanding economy has opened up new opportunities across industries, including smaller enterprises that are rapidly scaling operations. This shift has led many investors to explore new themes, and one segment getting attention is India’s growing small cap market.

Many investors believe that participating early in the growth journey of smaller companies may hold potential for long-term capital appreciation. This changing outlook has brought focus to one investment route: the small cap exchange-traded fund (ETF).

In this article, we will understand what small cap ETFs are, who may consider them, how to evaluate these ETFs, and examples of small cap ETFs available in India.

Table of contents

• What are small-cap ETFs?
• Why invest in small-cap ETFs now?
• Criteria for selecting the small cap ETFs

What are small-cap ETFs?

A small cap ETF is a market-linked investment product that tracks a small cap index. As per SEBI’s categorisation, small cap stocks are those ranked 251 onwards in terms of market capitalisation on recognised exchanges. These companies are usually in the early stages of business growth and are smaller in size compared to large and mid cap companies.

A small cap ETF aims to replicate the performance of its underlying index. Instead of buying individual small cap stocks, investors can purchase ETF units, which represent a basket of small cap companies. Investors who prefer passive investing, liquidity, and long-term wealth-building potential may explore these ETFs after understanding their risk profile. However, investors must note that while small cap ETFs provide diversification and transparency, they also carry higher risks compared to large cap and mid cap funds, including greater volatility, liquidity challenges, business risk, and potential for sharper drawdowns during market corrections

Read Also: Is 2025 Right for Small Cap Investments in India?

Why invest in small-cap ETFs now?

Growth potential over the long term

Small cap ETFs invest in companies that are still in the early stages of expansion but may have room to grow over time. Many of these firms operate in emerging sectors or niche markets and work toward increasing their scale, customer base, and profitability.

Investing in small cap ETFs provides exposure to businesses that may become tomorrow’s established players. If these companies perform well and grow over the long term, their market value may rise, leading to potential capital appreciation for investors. However, small cap ETFs are classified as very high risk due to their higher volatility. They may be suitable for investors with a long-term horizon and a relatively higher risk appetite.

Strong diversification benefits

Including small cap ETFs in a portfolio may enhance diversification. The small cap segment in India is broad, covering several industries and themes. By investing in a basket of such companies, investors distribute exposure across multiple sectors rather than relying on a few large players. This helps create a more balanced portfolio when combined with mid cap and large cap investments.

Opportunity in under-researched companies

Small cap stocks often receive comparatively lesser analyst coverage than large and mid caps and less attention from large institutional investors. As a result, some of these companies may remain undervalued despite sound fundamentals or promising business prospects. This limited research coverage may create potential opportunities for long-term investors who wish to participate early in the growth story of emerging businesses.

Read Also: What Is Small Cap? Meaning, Risks & How to Invest

Criteria for selecting the small cap ETFs

Understand your risk appetite

Small cap ETFs experience relatively higher volatility than large or mid cap ETFs, with sharp price movements possible over the short to medium term. Investors must assess their ability to tolerate such fluctuations before investing. Those comfortable with market ups and downs in exchange for potential long-term growth may find small cap ETFs suitable.

Evaluate tracking error

Small cap ETFs are passive in nature and replicate an index, seeking to match its performance. However, there tends to be some difference between the index’s performance and that of the fund, known as tracking error. Look at the fund’s tracking error and identify ETFs with lower tracking errors. Also look at the benchmark index and its methodology and portfolio.

Align with your investment goals

Align small cap ETF investments with long-term financial goals. Since the underlying companies may take time to potentially grow and their stocks may see high volatility in the short term, they may suit aggressive investors willing to remain invested for seven years or more.

Check the expense ratio

The expense ratio is the fee charged by the AMC for managing your investment. Compare expense ratios among ETFs in the same category, as lower costs can have a meaningful impact on potential returns over the long term.

FAQs

Are small cap ETFs suitable?

Small cap ETFs may be suitable for investors seeking long-term participation in smaller, developing companies and who are comfortable with relatively higher volatility. The potential for wealth creation exists, but risks are also significant. They may not be suitable for investors with short-term goals or those who cannot tolerate high volatility. Researching thoroughly and consulting a qualified financial expert may be helpful.

What is the difference between small cap ETFs and small cap mutual funds?

Small cap ETFs and mutual funds both invest in companies with smaller market capitalisations, but they differ in how they’re traded and managed. ETFs are passively managed and listed on stock exchanges, allowing intraday trading like shares. Mutual funds, on the other hand, are usually bought or sold at the end-of-day NAV and may be actively or passively managed. ETFs require a demat account to trade.

What risks should investors consider before investing in small cap ETFs?

Small cap ETFs carry higher market risk compared to large cap ETFs due to the relatively smaller size in terms of market capitalisation and comparatively lower liquidity of underlying companies. Price movements can be more volatile, and these funds may be more sensitive to economic downturns. Hence, diversification and careful position sizing are key.

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.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed.The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.