Should I invest in small cap funds?

The question should not be if you should invest or not. The question should be focussed on how much you can invest. Small cap mutual funds are an equity mutual  fund category. Mutual funds, as a category, pool money from investors and invest the corpus in the underlying assets. Equity mutual funds invest your money in stock of different companies and debt mutual funds buy bonds. 

They do not suit all kinds of investors. Lets understand what these funds are like to conclude how much exposure we should have towards the category.

Coming to your question, small cap mutual funds invest in stocks of small cap companies. Just like large cap mutual funds will invest in large cap stocks,mid cap funds in midcap stocks, multi cap funds in stocks of varying market caps and so on and so forth.

What defines a small cap stock?

Since small cap funds invest in small cap stocks, we should know what the term means. Small cap means those companies who have the lowest market capitalisations in the  industry. Small cap companies generally have a market value in the range Rs 0-5,000 crores, while mid cap companies’ value ranges from Rs 5,000 to 20,000 crores and large cap companies go beyond that.

When it comes to listed companies and defined by their market cap, Securities and Exchange Board of India (Sebi), our markets regulator has defined sme rules. 

The top 100 listed stocks by m-cap will be large cap stocks, 101-250 will be mid cap stocks and small cap stocks are stocks that begin from 251 and below. Nippon India Small Cap Fund direct Growth is an example of small cap funds that has been in the market since 2013 and has been investing in small cap stocks ever since.

Nature of small cap funds:

Small scale: 

Small cap funds like mentioned before invest in small cap stocks. hence they borrow their nature and characteristics from their underlying assets.

Small cap stocks are shares of smaller companies. They might either be new companies in the market who have just begun their journey or some may also be older companies of businesses with smaller cases. 

Volatile:

Small cap stocks are volatile in nature. Meaning, the tendency for these stocks to go too high or too low in terms of returns during a shorter period of time is very high. Small cap stocks may be high returning but the stocks are extremely volatile. 

Risk and returns: 

Small cap companies are riskier in terms of future growth trajectory. They have not been long enough in the industry and have not withstood as many disruptions as compared to the others. Even the best small cap funds are risky. They do offer better returns in terms of numbers but because of their scale, size and availability of resources at hand they are more vulnerable to downfalls than large cap companies, which have the resources to bring themselves back on track after a bearish event. 

Risk and returns are always correlated and directly proportional. If the returns from a certain investment is higher as compared to others, so will be the risk.  In the case of small cap mutual funds, the returns may be higher than large cap funds but the risk is higher too. 

If you can tolerate emotionally and financially seeing your money going down in the short term and have sufficient surplus funds to help you sail through, it means you have higher risk.

Also if the returns are high, look into the reason why they are high. Like, BOI AXA Small Cap Fund Direct Growth returned well in the first half of 2020 because until July 2020 most of its exposure was towards healthcare stocks. Healthcare as a sector has performed well during the covid-19 pandemic.

Should you invest in small cap funds?

Knowledge: Small cap funds suit those investors who have more market knowledge. To be able to have some exposure in risky investments, you should have the apt knowledge of mutual funds, how they work and stock markets as well.

High Risk: If you have a higher risk profile and sufficient surplus capital at hand  to invest, you can opt for small cap funds. However, diversification is key. Even if you have a high risk profile, it does not mean you invest only in small cap funds. It simply means that a larger chunk of your money can be in small cap funds while the rest in safer assets.

If you have a low risk profile, it does not mean you completely avoid small cap stocks. It  just means you keep your exposure low towards this category.

Time: This is one of the most important things you need. Time. For investing in stocks, you should have a long term horizon in mind, which is at least five years. Like mentioned before, small cap stocks are volatile and in the short term you will not be able to churn good returns. Stay invested for a long tenure.

Taxation: Gains generated during the short term is known as short-term capital gain tax and will be taxed at the rate of 15%. Short term is defined as a period of less than a year. However, gains generated from shares that were held over a year would attract long-term capital gain tax and will be taxed at the rate of 10%.

Conclusion:

Small cap mutual funds have the ability to generate high returns but few important factors you need is patience, time, high risk, capital and financial knowledge. Check which are the holdings in the fund, how often does the fund change its holding to respond to market fluctuations, the fund manager’s overall performance and few financial metrics as well. Conduct some research and make a well informed decision.