Small-cap funds are one of the preferred investment options for investors across the board. They are a type of equity mutual fund classified based on market capitalization. Here are some key facts and benefits of small-cap funds you should know before investing:
- What are small-cap funds?
A type of equity mutual fund where most investments are made in the equity instruments of small-cap companies. Small-cap companies have a market capitalization of less than INR 5,000 crore. According to SEBI, a small-cap mutual fund is a scheme where 80% of the total assets are in small-cap companies.
These funds are riskier when compared to other equity funds. However, they promise a high return, sometimes to the tune of double or triple. Most investors turn to these funds when they need high returns in a short time frame.
- Facts and benefits of small-cap funds
Here are some interesting facts you should know about small-cap funds:
Investment risks and returns: The risk of investment posed is high even though they offer solid returns. It is a good idea to add such funds to your investment portfolio to act as a buffer when the market is good.
Cost of investment: The expense ratio of small-cap equity funds is capped at 2.50%. When you are choosing a fund for investment, make sure to take into account the return post-expense ratio so that you get a more realistic estimate. Ideally, you should opt for a fund with a low expense ratio to enjoy better returns.
How long should you stay invested: The value of small-cap funds can quickly erode when the market starts plummeting. Ideally, a 7 to 10-year period is a good time frame for reaping maximum benefits from such funds. Buying a home, paying for your children’s education, and saving for retirement are some investment goals you can keep in mind while investing in these funds.
Tax treatment: Capital gains from small-cap funds are taxable. When the holding period (investment period) is more than one year, it is classified as long-term capital gains and taxed at 15% when the amount exceeds INR 1 lakh. The holding period of less than a year is known as short-term capital gains, taxed at 15%. Moreover, before paying out dividends, the Dividend Distribution Tax of 10% is also deducted by the fund houses.
Who should invest in these funds: These funds are best suited for someone with a high-risk appetite and a long-term investment goal. However, keep in mind that your returns can reduce significantly when the market takes a downward turn. You must also take into account that small-cap companies are more prone to following an aggressive growth strategy. This can leave their shares more volatile and vulnerable to changes in the market. Similar to any other investment, it is impossible to insulate investment in small-cap funds against losses completely.
Liquidity ratio: The liquidity ratio of mutual funds denotes the number of days it will take for a portfolio manager to close down the portfolio without adversely affecting the price of the scheme. The ratio is calculated by CRISIL. In the case of small-cap funds, the ratio is 25 days. As a rule of thumb, the lower the current ratio, the better it is for the fund, as it shows stability.
Here are the benefits of investing in small-cap funds:
Growth potential is high: The scope of growth of small-cap companies is very wide. As a result, small-cap funds also have high growth potential.
Undervalued investments: Since small-cap companies are not on top of everyone’s wishlist, the chances of getting good returns from small-cap mutual funds are higher as there is always a possibility of such companies being undervalued. This makes it a good investment opportunity.
Good for making your portfolio diverse: When you have small-cap funds in your portfolio, the overall risk-return trade-off gets stabilized. You can enjoy a reduced risk by diversifying your investments.
A fair chance of value getting appreciated: Small-cap companies always have a chance of getting merged with other companies or getting acquired by a large-cap company. This growth potential can increase the stock price of small-cap companies, providing better returns on the small-cap fund.
Liquidity is on the lower side: The shares of small-cap companies are thinly traded. There is better availability of the shares in the market as hordes of investors are not chasing them. Lack of high demand helps to maintain prices on the lower side which is beneficial for investors.
Small-cap funds are an excellent investment option for those investors who have a steady portfolio and don’t mind taking risks. When the market is bearish, such investors stand a good chance of getting high returns. On the flip side, when the market plummets, returns can be affected significantly. Ideally, it would help if you only diverted a portion of your funds towards these mutual fund schemes so that you don’t end up losing a chunk of your hard-earned money.
If you are unsure how to pick the right small-cap funds for your investment portfolio, get in touch with our experts at Moneyfront. We are happy to help you make the right choices.
It is recommended that you have a small portion of your investment portfolio dedicated to the best small-cap funds.