What are Small Cap Mutual Funds & Are They A Good Investment?

Small-cap mutual funds are a type of equity mutual fund that are required to invest at least 80% of their investible corpus in equity or equity-linked instruments of small-cap companies. This definition of small cap funds is as per SEBI guidelines and each mutual fund company or AMC (Asset Management Company) is allowed to offer investors only a single scheme in this category.

SEBI has also provided guidelines regarding which stocks belong to small-cap companies. As per current rules, small cap stocks are those that are ranked below the 250th position in terms of market capitalization. So, these equity schemes are primarily engaged in making investments in relatively small companies. As such smaller companies might have limited cash-flow, they are prone to adverse impact of market fluctuations, small cap equity schemes tend to be more volatile as compared to large cap and mid-cap equity schemes.

Despite the potentially high risk involved, small-cap funds in India are highly popular because of their potential to offer high returns. The logic behind these funds' potential for higher returns is simple to understand. A small company has a significantly high scope for growth and become more profitable in the future, so its value can increase significantly in the long-term. Therefore, experts suggest that small-cap mutual fund investments are best suited for investors who have a high-risk tolerance and planning long-term investment of at least 5 years or longer.

After keeping the definition and meaning of small-cap funds in perspective, the associated risks will not be difficult to understand. These equity mutual fund schemes are considered to be riskier that other equity investments such as large cap funds and multi-cap funds because it has four kinds of risks. They are:

An experienced investor wouldn't invest in any instrument without carefully evaluating the market and individual factors. Let us look at some things worth considering before investing in small-cap mutual funds:

Now that you know the basics of small-cap funds, understanding who should invest in it will not be difficult.

Investors purchase small-cap funds aggressively despite more volatility and comparatively lesser liquidity. This is because they can offer high returns in the long term. In fact, the average return rate for a small-cap mutual fund for an investment period of at least 5 years is almost 15% p.a.

So, to answer it in brief, investors who are ready to take risks and intend to make the most of their portfolio by investing for a longer time can choose to purchase small-cap funds to generate high returns from their investments.

Considering the significantly high risk involved as compared to other equity or debt mutual funds, it is suggested that small-cap schemes should form a relatively smaller portion of your overall portfolio, typically no more that 20% of your overall investment. This is help you contain potential losses due to short-term volatility better. Also remember to conduct in-depth research of the scheme and consider its long-term track record before purchasing and investing in top small-cap companies.