Category : New to Investing January 21, 20265 minutes read
Small cap mutual funds invest in small cap equities, which generally rank below 250 on the Nifty index. Like most mutual funds, these schemes have certain pros and cons which investors must consider before starting an investment. Some benefits of small cap mutual funds include potential for significant wealth creation in the long run, portfolio diversification, active fund management, and the option for SIP or lumpsum. However, small cap fund investments can entail certain risks, including vulnerability to volatility and business sustainability risk. Another factor investors must consider is the liquidity issues that arise while investing in small cap funds due to their limited trading volumes. Thus, before investing, investors must consider the risks and benefits of small cap funds.
Small cap equity mutual funds are investment schemes that enable investors to gain exposure to small cap equities present in the stock market. Like most mutual fund investments, small cap mutual funds are subject to certain pros and cons. Before starting an SIP or lumpsum investment in small cap funds, investors must consider the benefits and drawbacks of the scheme to assess its suitability to their investment portfolio.
Due to the investment strategy, small cap funds have many benefits. These include:
High Potential Returns
Small cap funds invest in small cap companies, which are generally new to the market and in the early stages of the business cycle. Consequently, these companies and stocks have high potential for growth. As the company expands and the stock matures, stock prices can increase substantially. High potential returns are one of the key benefits of small cap funds; however, these potential returns are generally realised in the long-run. Moreover, the performance of the small cap fund determines the long-term returns.
Portfolio Diversification
Small cap mutual funds invest in stocks of several small cap companies. These companies may belong to various sectors, including healthcare, pharmaceutical, IT, finance, consumer goods, manufacturing, renewable energy, etc. This variation in sectors allows small cap funds to gain benefits from across the market. Slow down in any one sector may be compensated for by investments in another sector. Although the scheme does not diversify across market capitalisations, diversification across sectors enables investors to manage overall portfolio risk.
Access to Emerging Opportunities
As small cap mutual funds invest in small cap stocks, investors get access to firms that may have just entered the market. Small cap companies are often in early stages of growth and may operate in niche markets with significant potential in the long run. Since small cap companies are smaller and less followed by analysts, they can take risks and capitalise on new ideas and innovations. Investing in small-cap mutual funds allows investors to gain exposure to these high-growth opportunities early and potentially benefit
from the returns of the small cap fund. As these small companies expand and mature, substantial long-term returns may be created.
Potential Long-Term Gains
Small-cap companies typically have greater room to grow as compared to established large-cap firms. These small companies are generally still expanding their operations, market reach, and product offerings, and over time, with effective management and favourable market conditions, they have the potential to grow at a faster pace over time. Investors who remain invested in small cap mutual funds over a long term may benefit from compounding and significant capital appreciation as successful small-cap businesses evolve into mid- or large-cap companies.
Read more about the power of compounding!
Active Fund Management
Small cap funds are actively managed funds. These are generally beneficial for investors who prefer an active approach to investing but do not have the skill and expertise to manage their portfolio on a daily basis. The fund may change its asset allocation based on market conditions, macroeconomic factors, and company performance, while maintaining the minimum required allocation in small cap equities as per the mandate. Active management may enable investors to avoid certain sector-specific risks and potentially outperform the underlying market index.
Option for SIP or Lumpsum
Investors can choose to invest in small cap funds through Systematic Investment Plans (SIP) or through lumpsum. Investors choosing to start an SIP in small cap funds may invest a minimum of ₹500 monthly, thus making this an accessible option for any investor. Systematic Investment Plans (SIP) allow investors to potentially benefit from Rupee Cost Averaging (RCA) and compounding in the long-run, which means that any returns get re-invested, significantly impacting the growth.
Investors who have a large sum of money and wish to invest it immediately may start a lumpsum investment in a small cap mutual fund. Any amount can be invested, and investors may gain the benefits of compounding.
High-Risk
Small cap funds are generally considered a very high-risk investment option. This is because they invest in companies that may have just entered the market. Although new companies generally have the potential to grow they may also fall victim to business uncertainties and economic downturns. Also, small-cap companies have limited financial stability and lower market visibility, because of which they may experience changes in performance that are difficult to control. This influences the performance of small cap funds, making them suitable for investors who can remain invested for a longer time frame.
Highly Volatile
Small-cap equity funds are highly volatile because they invest in smaller, lesser-known companies whose stock prices can change a lot over short periods. These companies are more sensitive to market sentiment and have limited external investment. Economic changes and industry-specific developments impact the performance of the small cap fund more prominently. As a result, small-cap funds may experience extreme changes, that is, sudden gains or steep declines.
Liquidity Issues
Compared to large-cap stocks, smaller companies’ stocks are frequently traded in lower volumes. Liquidity problems result from this, which are typically regarded as a significant risk when investing in small-cap equity funds. This typically occurs when there are fewer buyers and sellers in the market, making it challenging to purchase and sell shares at a reasonable price. Lack of liquidity can cause price drops or delays in selling investments during times of market stress. Because they may encounter difficulties when attempting to redeem their investments, small cap funds might not be appropriate for investors seeking a liquid investment.
Sensitivity to Market Fluctuations
Small-cap equity funds are highly sensitive to market fluctuations. This is because they invest in smaller companies that are more vulnerable to changes in economic and market conditions. Interest rate changes, inflation, economic slowdowns, or shifts in investor sentiment may impact the performance of small cap funds significantly. Moreover, when the market is uncertain or market downturns occur, investors often move away from riskier assets, causing small-cap stocks to decline more sharply than large-cap stocks. As a result, small-cap funds may experience greater short-term volatility, making them better suited for investors who can tolerate risk and stay invested through market cycles.
Limited Availability of Information
Small-cap companies often emerge from niche markets or have just entered already existing markets. There is generally limited availability of information regarding these companies and markets as compared to large, well-established firms. Analysis of the performance of small cap companies can be difficult compared to blue-chip companies since small cap firms are unlikely to regularly disclose detailed financial data or future growth plans, making it difficult for financial advisors and analysts to accurately predict performance. This lack of transparency increases uncertainty and risk for investors, as investment decisions rely more heavily on assumptions.
Business Sustainability Risk
Business sustainability risk is common in small cap investments. This is because many small-cap firms are new and may have unproven business models. Their long-term growth is difficult to predict and they may struggle to sustain their growth over the long term. Small-cap equity funds invest in companies that are in the early stages of development and may have a narrow customer base. As a result, maintaining consistent revenues and profitability over the long-term can prove difficult. They may also be more vulnerable to competition from larger, well-established bluechip companies. Limited access to capital and operational challenges add to the problems faced by small cap funds. All these factors can hinder their ability to scale efficiently. If these companies fail to adapt to changing market conditions or sustain growth, their long-term viability may be at risk, which can negatively impact the performance of small-cap mutual funds.
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Small cap funds have several pros, including higher potential returns, portfolio diversification, access to emerging opportunities, potential long-term gains, active fund management, and the option for SIP or lumpsum. Nevertheless, these schemes can be vulnerable to cons such as high-risk and high volatility, liquidity issues, sensitivity to market fluctuations, limited availability of information related to small cap companies, and business sustainability risk.
