What are the Features of Small Cap Funds?

Small cap funds have become increasingly preferable to long-term growth-oriented investors over the years. This is because they invest in companies with small market capitalisation, i.e., companies that rank below the 250 largest companies in terms of market size. Although considered more volatile than large-cap and mid-cap funds, they offer high growth opportunities. In this article, we will look into what are small cap fund, features, benefits, factors to consider and more. 

What are Small Cap Funds?

A small cap fund is a type of equity mutual fund that invests the majority of its funds in a company that is recognised to be a small cap. According to SEBI categorization, such a company ranks 251 and below in terms of market capitalisation.

Their smaller size can expose them to changing market cycles to a greater extent, but it also gives them flexibility and potential for growth. Therefore, small cap funds give investors the chance to take advantage of growth at its early stage of development. 

Features of Small Cap Mutual Funds

Understanding the features of small cap mutual funds can help investors decide whether they are appropriate for their risk profile and investment requirements. 

Exposure to Small Businesses

Investment is focused towards companies which have a relatively lower market capitalisation than mid cap and large cap companies. The aim is to invest in those companies that have the potential to become industry leaders in the future. 

Higher Growth Potential

Due to their smaller size, small cap firms are able to grow faster than their larger peers, thereby offering possibilities for long-term capital appreciation. 

Greater Volatility

Smaller firms typically face greater business and market risk. Therefore, their share prices can undergo greater volatility due to industry performance, economic cycles, or firm-specific events. 

Long Investment Horizon

Since small cap funds tend to be more volatile, they are generally suitable for investors with a longer investment horizon, typically five years or more.  Such a period of time allows the investment to recover from the drastic market changes. 

Active Fund Management

The majority of small cap funds are actively managed. The fund managers select stocks considering research, market potential, and financial health of the company. However, the performance may differ depending on the fund management’s approach. 

Potential Risks of Investing in Small Cap Funds

While considering a small cap fund, one should analyse the underlying risks.

• Risk of Liquidity: Small cap stocks may have low trading volumes, making it difficult to sell large positions without impacting the stock price.

• Market Risk: They are vulnerable to market decline or economic fluctuations.

• Business Risk: Certain small cap stocks may lack strong fundamentals, impacting performance in uncertain times.

Though they have risks, they may provide significant long-term performance if the fund is researched well and the investor remains invested during market fluctuations. 

Who Should Invest in Small Cap Mutual Funds

Small cap funds are not appropriate for all investors. However, they can be appropriate for the following types of investors:

• Investors with a high-risk tolerance

• Individuals looking for long-term capital appreciation

• Those looking for market cap diversification

• Seasoned investors familiar with market fluctuations

• Investors who prefer actively managed approaches.

Benefits of Small Cap Funds

Although such funds may have certain potential risk, they also have some benefits, such as:

• Exposure to business companies in their development stage

• The potential to create significant wealth in the long run

• Opportunity for diversification between industries and firms

• Actively managed funds that attempt performance-based stock selection.

Things to Look for Before Investing

Selecting the appropriate small cap mutual fund involves research. The points below must be considered:

• Fund Management: The fund manager must be skilled in managing small cap portfolios.

• Fund Performance: Consider long-term performance of the fund by researching its 5 to 10-year performance

• Expense Ratio: If a fund has a low expense ratio, it may enhance total investment gains.

• Consistency: Use consistency in the selection of stocks and risk management procedures.

• Investment Goal: Ensure the fund’s objectives align with your own financial planning.

Having a mutual fund application can help track these parameters and watch fund performance over time.  

Conclusion

Small cap mutual fund investments have growth possibilities and risks. Their growth potential relies primarily on what stocks are selected, when one enters the market, and the investor’s patience. For investors who understand market dynamics and can manage volatility, a small cap fund can be a preferable choice for long-term financial planning. Whether investments are made through an advisor or through a mutual fund platform like Axis MF, make sure that it aligns with your investment objectives and risk tolerance.