All you need to know about small cap index funds

Good things come in small packages. And, in the case of small cap index funds, this statement holds true in its entirety. With the influx of new investment vehicles over the past decade, small cap index funds can be suitable for new-age investors. These funds are being considered an opportunity to grow wealth over time. Through small cap index funds, any investor can participate in the growth potential of small companies as these companies have the capacity to grow in the long term.

This article will take you through the concept of small cap index mutual funds, their benefits, how do they work, who should invest, and factors to consider before investing in them.

Table of contents

• What is a small cap index mutual fund?
• Benefits of investing in small-cap index mutual funds
• How do small cap index mutual funds work?
• Who should invest in small cap index mutual funds?
• Things to consider before investing in small cap index mutual funds

What is a small cap index mutual fund?

A small cap index mutual fund is designed to mirror the performance of small-cap indices such as the NIFTY Smallcap 250 and BSE 250 Smallcap etc. The fund strategy involves investing in the same stocks as the underlying index and maintaining the same weights/proportions.

Additionally, small cap stocks refer to the companies that are ranked 251 and beyond as per market capitalisation on the stock exchanges. These are businesses that are often at the early stages of their growth journey.

Benefits of investing in small-cap index mutual funds

High growth potential

Small-cap companies often start from a lower base, which gives them more room to grow compared to large, well-established firms. As these companies expand their businesses and improve profitability, their stock prices may rise significantly. For investors, this means the potential for relatively better returns over time, especially if you get in early and stay invested.

Diversification

Small-cap index funds spread your investment across a variety of small companies, reducing the risk of relying on a single stock’s performance. Even if one company doesn’t do well, others in the portfolio can balance it out, making your investment relatively less risky than putting all your money into one stock.

Cost-effectiveness

Small-cap index funds are simple and low-cost because they are passively managed, and their portfolio mirrors a specific index. This means fewer expenses, so you get to keep more of the money your investment earns.

Access to emerging companies

These funds let you invest in upcoming, smaller companies that have the potential to become tomorrow’s market leaders. Think of it as being part of the early success story of future giants.

Long-term wealth creation

Small-cap index funds can be suitable for those who can stay invested for a long time. Over the years, as these small companies grow, your money grows with them. This steady growth can add up to create wealth in the future.

How do small cap index mutual funds work?

Small Cap Index Mutual Funds aim to copy the performance of a small cap stock market index, like the Nifty Smallcap 100 or the BSE SmallCap Index etc. These funds invest in a group of stocks that make up the index, trying to match its returns and structure.

Fund managers ensure the fund reflects the index by holding stocks in the same proportions as the index. If the index updates or changes its stocks, the fund managers adjust the fund’s investments to stay in sync.

When you invest in a Small Cap Index Mutual Fund, you indirectly own shares in the small cap companies included in the index. This could give you an opportunity to benefit from the growth of these smaller, fast-growing companies. Furthermore, since the fund spreads your money across many companies, it spreads the risk compared to investing in just one or two stocks.

Who should invest in small cap index mutual funds?

People comfortable with risk

If you don’t mind ups and downs in the market, these funds could be a suitable option. Small cap stocks often see big price fluctuations, so you need to handle a high level of risk, especially in the short to mid term.

Long-term planners

These funds need time to potentially show favourable returns. If you are willing to invest and show patience, they might work for you.

Seeking variety

If your portfolio mostly has large or mid cap stocks, small cap funds can add some variety and balance to your investments.

Young investors

If you are just starting out and have a long horizon, these funds are an easy way to invest small amounts and utilize the full potential of equity appreciation and compounding.

Things to consider before investing in small cap index mutual funds

Understand the risk

Small cap stocks are more volatile than large cap stocks. Be ready for some price fluctuations, especially during market downturns.

Think long-term

These funds need time to show results. Aim to invest for at least 5-7 years to balance out short-term ups and downs.

Check costs

Small cap index funds are usually low-cost, but it’s still a good idea to compare expense ratios between different funds to get the most value.

Look at the track record

Make sure the fund has a solid history of closely matching the returns of its index. Tracking record can get you a better approach. A lower tracking error shows that the fund follows the underlying index closely.

Know the market conditions

Small cap stocks are affected by what’s happening in the economy and markets. Keep an eye on current trends before investing.

Conclusion

Small cap index funds aims to offer an opportunity for investors seeking high growth potential in the long term and diversification. However, they come with inherent risks and require a long-term commitment. By understanding how these funds work and evaluating your financial goals, risk tolerance, and investment horizon, you can make an informed decision. As always, consult with a financial advisor to ensure your investment aligns with your overall financial plan.

FAQs:

What is a small cap index mutual fund in India?

A small cap index mutual fund in India is a fund that tracks the performance of a small cap index, such as the Nifty Smallcap 250 Index. It invests in the same companies listed in the index, offering investors exposure to smaller, high-growth potential businesses.

What is a good small cap index mutual fund?

A suitable small cap index mutual fund is one with a low expense ratio, a strong track record of matching its benchmark’s performance (low tracking error) and a transparent fund house with reliable management.

Is investing in a small cap index mutual fund good?

Investing in a small cap index mutual fund can be a suitable approach for long-term investors seeking high returns and diversification. However, these funds are very high risk and require careful consideration of market volatility.

Are small cap index mutual funds risk-free?

No, small cap index mutual funds are not risk-free. They are subject to market risks, including high volatility and potential losses, especially during economic downturns.

How long should you invest in small cap index mutual funds?

To optimize returns and reduce the impact of market volatility, it’s advisable to invest in small cap index mutual funds for at least 5-7 years.

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 an 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.