Small Cap Funds

What Are Small Cap Funds?

Small cap equity mutual funds invest in companies that rank below 250 in terms of market capitalisation. Since 2018, all stocks are indexed descending on market capitalisation. Small-cap funds have to invest at least 65% of their corpus in small cap stocks. They invest in small revenue companies that have a market capitalisation of less than 5000 crore rupees. The funds are volatile in nature, but the small revenue companies they invest in have high growth prospects in the long term. You have to bear in mind that these companies are generally not diversified and they focus on a single line of business.

Who Should Invest in Small Cap Funds?

  • Small caps can even double or triple in value over the long run in a bull market, so they are a great addition to your portfolio in spite of posing a significant amount of risk. Hence, these funds are perfect for investors who have an appetite for risk. These funds tend to outperform large cap funds in the long run provided you buy them early in a bull market. However, in a bear market, the mid and large cap funds outperform the small caps
  • It is best to invest in small caps for a period of 5-7 years because in a bear market small caps perform poorly. These funds are ideal for investors who have a long investment horizon. You should have some long term goals in mind while investing in small caps. You can plan for your retirement, your children's education or buying a retirement home when investing in these funds for the long term
  • These funds work well for investors who want a diversified portfolio by holding small cap, mid cap and large cap funds. In a bull market these funds outperform large caps, while in a bear market investment in large caps can help improve the performance of the portfolio since small caps underperform in a bear market
  • If you are a patient investor, a small cap fund is perfect for you. Never panic and sell or buy in a hurry. You need to be patient to book profits when you buy a small cap fund. Don't try to time the market

Taxability of Small Cap Funds

  • Capital gains refer to the amount of money that is earned in excess of the investment when you redeem a small cap equity fund. Capital gains depend on how long the money was invested in the small cap fund. The number of years for which you invested your money in small caps is called the holding period.
  • If the holding period is up to one year then the short term capital gains are taxed at 15%. In case the holding period is greater than 1 year, then the gains are called long term capital gains. The long term capital gains of over one lakh are taxed at 10%.

Risk Involved With Small Cap Funds

  • It is best to invest in small cap mutual funds through a systematic investment plan to reduce volatility since these funds are risky. A systematic investment plan is one wherein you invest a small amount of money periodically at predefined intervals in the small cap fund instead of a lump sum amount of money in one go. This is to ensure that you benefit in the long run regardless of the market dynamics. The compounding effect of your investments ensure that you earn not only on the principal amount but also on the gains on the principal
  • Small Caps perform poorly in a bear market so the consistency of the funds and the downside risk should be taken into account while forecasting the performance of the funds. The consistency of a fund is measured by the Hurst exponent. The downside risk is the estimation of the fund’s loss in value if market conditions cause a decline in the security prices
  • Small caps carry a higher expense ratio than large cap funds so your net small cap fund return post expenses may be lower than what you expect. Although an expense ratio with an upper limit of 1.5% is preferred, small caps typically have a an average expense ratio that is higher. This is because small cap mutual funds have to conduct primary research and have many analysts contribute to the research. The reason for this is that small cap stock research is not as easily accessible as large cap stock research. The best small cap funds are the ones with an expense ratio of less than 1.5%.

Advantages of Small Cap Funds

High Returns In a Bull Market

These funds invest in companies that have high-risk high-return potential. The small cap fund returns are generally high in a bull market, but it is important to look at the track record of the small caps before investing in them. The returns over a five year period should be studied to understand the performance of the best small caps.

Help to Diversify Your Portfolio

Small caps help to diversify your portfolio. Funds can be shortlisted after taking into account their mean rolling returns rolled daily for the last three years. Rolling returns are the annualised average returns for a period ending with the listed year. These returns can examine the behaviour of small caps for the holding period. The rolling returns give the performance of the fund smoothened over several periods throughout its history.

The small cap category has offered a return of 37.79% in the last year. Investors believe that the small cap category may repeat its performance in 2022. Remember small caps are a risky investment and you should not try to time the market. The best practice is to simply invest in small caps for the long term.