What is a small-cap fund?
A small-cap fund is a mutual fund that invests at least 65% of its pooled money in shares of small-cap companies. Small-cap companies are those firms whose market capitalization is generally below Rs. 5,000 crores and ranked 251 or below among listed companies on the exchange.
Small-cap funds invest some portion of their corpus in mid- or large-cap stocks to stabilize their portfolio. While small-cap funds are some of the best-performing funds for 10 years, they are also prone to volatility, making them riskier than large-cap or index funds.
The high-risk nature of small-cap funds doesn’t make them a suitable investment option for all investors.
Why are small-cap funds not for all kinds of investors?
Some of the best small-cap funds such as the Nippon Small Cap fund or the Quant Small Cap fund have given stellar returns in the last five years. But does this mean small-cap funds are a holy grail of investments suitable for all investors irrespective of their risk appetite? Let’s find out.
When it comes to risk, investing in shares of a small-cap company is much more riskier than investing in mid-cap or large-cap shares. Small-cap mutual funds invest at least 65% of the pool in small-cap stocks. So, if you are looking for a high-risk, high-return investment, investing in a small-cap fund will serve your purpose.
But, if you are looking for a relatively safe investment with less volatility, an index fund will serve you better.
In short, small-cap funds have a different risk profile compared to index funds or large-cap funds. A risk-tolerant investor can invest in a small-cap fund, but a risk-averse investor should stay away from a small-cap fund as the fund may not suit his risk appetite.
Additionally, when it comes to investments, there is no one-size-fits-all solution, and thus, no mutual fund is ideal for all kinds of investors. For instance, a risk-seeking investor will be dissatisfied with an index fund, while fluctuations of a small-cap fund would unnerve a risk-averse investor.
- Risk
Small-cap funds pose a significant risk and this may translate to losses in the short run. Therefore, if your aim is capital preservation in the short term, small-cap funds are not for you. This is because markets may be volatile in the short run, leading to losses.
Additionally, if you are the type of investor who cannot afford to see their investments in the red even for a short period, small-cap funds are not suitable for you. This is because, while small-cap funds give good returns over the long term, market volatility can lead to them lose value in the short term.
- New Investor
If you are new to equity markets and mutual fund investing, don’t get swayed by expectations of high returns and start investing in a small-cap fund without understanding the risks associated with them.
As a new investor, you would be better off starting your investment journey with an index fund and then diversifying into higher-risk funds as you start comprehending the risks with equity investments.
- Short-Term Investor
Small-cap funds are long-term investment products, with capital appreciation as the investment motive. Therefore, they are not suitable for short-term investors who look for capital preservation over capital appreciation.
How to invest in small-cap funds
Here are some ways to invest in small-cap funds:
- SIP/STP
A systematic investment plan/systematic transfer plan involves investing a fixed amount of money at regular intervals, such as monthly or quarterly. SIP is where you invest a fixed amount of money from your bank account, whereas STP is when you transfer a fixed amount from one investment to another automatically. Under STP, the units are redeemed automatically at a fixed date and investors need not do anything.
- Long Term
Small-cap funds are long-term investment products. These are not recommended for short-term investments as investors might lose money in the short term. It is recommended that you stay invested in the product for more than a year if you are looking to invest in a small-cap fund.
Conclusion
While the best small-cap funds generate amazing returns in the long run, the inherent risk of the product doesn’t make it suitable for all investors. Investments in small-cap funds should only be made by risk-tolerant, long-term investors.
