Small Cap Mutual Funds

As per the SEBI’s classification, small-cap mutual funds are equity funds that invest at least 65% of their total assets in small-cap stocks.

Small-cap stocks belong to companies that rank from 251st onwards on the stock exchange by market capitalisation. Historically, small caps have outperformed large-caps during market recoveries/bull runs.

As per a report by Goldman Sachs, 70% of all multi baggers in India since 2000 have belonged to the small cap universe.

High growth potential

Small-cap funds primarily allocate their investments to small and growing businesses. Thus, they inherently have a significant potential for delivering robust returns. Small-cap funds invest in companies that are in their early stages of growth. It is quite possible for these companies to generate high earnings and profitability. As a result, the stock returns tend to be high.

The average category return of small-cap mutual funds has outperformed both large-cap and mid-cap funds in various time periods. For example, in the last 10 years, the category average annualized return of smallcap was 21.73%, compared to 13.31% for large-cap funds and 19.94% for mid-cap funds.

Source: AdvisorKhoj

Diversified Portfolio

Small-cap mutual funds give exposure to more diversified and unique sectors (21 sectors) than large-cap funds.

High volatility

Small-cap funds have the highest volatility among all mutual funds. Volatility is the rate at which the stock prices increase or decrease over a particular period. In volatile market scenarios, small caps stocks tend to fluctuate more than large caps and mid-cap funds.

The table below shows the standard deviation of the benchmarks. Standard deviation measures the volatility of mutual fund returns. It's quite clear that small-cap funds have the highest volatility. 

Note: The SD values are as of 29th September 2023 and are annualised.

Liquidity

Liquidating small-cap fund holdings can be the biggest concern for AMCs when the markets are highly volatile. These stocks have a small capital base, and their trade volumes are also lower. Thus, making it difficult for the fund to exit some investments. However, investors' redemptions are always honoured by the fund house. 

Requires long term investment commitment

In general, equity investments are highly volatile. A long-term investment tenure will help average out the impact of volatility. And, of all, small-cap funds have the highest risk. Therefore, a long-term investment tenure is a must. 

Let's look at the rolling returns for the Nifty 100, Nifty Midcap 100, and Nifty Smallcap 250.

Source: Advisorkhoj

The table above captures the probability of each index giving negative returns over the specified durations. Taking a closer look, the Nifty Smallcap 250 index has the highest probability of generating negative returns in the short term. However, a declining trend is evident over the years. Thus, proving a long-term investment commitment will help generate high returns.

Before you invest in small-cap funds, you should consider your risk appetite and how well your portfolio is diversified. A financial advisor can help you make a decision based on your situation and existing portfolio.

Investors seeking high-risk investments can consider small-cap mutual funds. Since small-cap funds are high-risk, they have a high return potential. However, these high returns come at a cost - high volatility and drawdowns during market crashes. Thus, small-cap mutual funds are not everyone, and investors must be mindful of the associated risks. 

Note: The above information is for educational purposes only. It is best to consult a financial advisor before making investment decisions.