Small cap funds are mutual funds that invest primarily in stocks of small companies. Small companies are those whose market capitalization is below a certain threshold defined by Securities and Exchange Board of India (SEBI). Small cap companies have a huge potential for growth but also come with higher risks compared to large cap companies. This article aims to provide all the key aspects about small cap fund that an investor needs to know.
What are the key characteristics of small cap companies?
Small cap companies are defined as those with a relatively low market capitalization, below Rs. 5000 crores as per SEBI guidelines. They tend to be new entrants in the market as well as are in the growth phase of their business lifecycle. Small caps offer high growth potential since they have scope for significant expansion in their sector. However, they also come with higher risks compared to large caps. The risks include volatility in stock prices along with higher chances of business failure. Additionally, shares of small cap companies have lower liquidity since their trading volumes are not as high as large caps. It can be difficult for retail investors to find adequate financial as well as operational information about small caps as they are not as widely tracked or researched as large caps.
Why invest in small cap funds?
Small cap companies offer the potential for higher returns compared to large caps due to their higher growth nature. However, investing directly in small caps comes with greater risks at the company level. Small cap funds help address this by diversifying across 30-50 small cap stocks belonging to different sectors. This diversification reduces company specific risks for investors. In addition, fund managers are better equipped to research as well as identify small caps with good long-term prospects through their dedicated research teams. Small cap funds also provide greater liquidity compared to direct investing in often illiquid small cap shares. Investors can easily exit at the day’s net asset value from a small cap mutual fund. Further, small cap funds have lower costs than directly constructing such a diversified small cap portfolio.
Things to consider before investing in a small cap fund
Small cap funds are high risk investments that require careful evaluation along with planning. Given the volatile nature of small cap stocks, investors must have a high-risk appetite as well as long term investment horizon of 5-7 years. It is important to assess the fund manager’s past performance in identifying winning small cap stocks consistently over many market cycles. Diversifying one’s equity investments across large, as well as mid along with small cap funds can help balance risk along with returns. Lumpsum investments in small cap funds are not advisable due to volatility. Investors are recommended to start SIP or systematic investment plans to benefit from rupee cost averaging as well as reduce risks. Overall, small cap funds demand a disciplined approach with the right fund selection as well as exit strategy to deliver higher returns in the long run.
Conclusion
Small cap funds are ideal for investors looking to participate in the higher growth potential of small companies while mitigating risks through diversification. However, they require a long-term mindset as well as higher risk tolerance. By choosing the right fund between mutual funds vs sip, maintaining discipline through SIPs along with diversifying one’s equity portfolio, investors can benefit from small cap funds to grow their wealth over the long run.
