Category : New to Investing February 6, 20265 minutes read
Small cap investments have gained popularity among investors seeking higher growth potential over the long term. In the Indian equity market, small cap stocks represent companies ranked below the top 250 by market capitalisation and are often at an early or expansionary stage of their business lifecycle. While these companies can offer significant upside during favourable market conditions, they are also more volatile and sensitive to economic and market changes.
Investors looking to participate in this segment can do so through two primary routes: small cap index funds and actively managed small cap mutual funds. Small cap index funds follow a passive investment approach, aiming to replicate the performance of a small cap index at a relatively low cost. In contrast, small cap mutual funds are actively managed, with fund managers attempting to identify high-growth opportunities and outperform the benchmark.
Understanding the differences between these two approaches—across risk, returns, costs, and management style—can help investors make more informed decisions aligned with their financial goals and risk appetite.
The small cap index is a Nifty market index which comprises companies that are ranked below 250 on the Indian stock market. These companies generally have a market capitalisation of below INR 5000 crore. Indices such as the Nifty Smallcap 250 or the BSE Small Cap Index are some of the indices on the Indian stock market. Companies included in these indices are often at an early or expansionary stage of their business lifecycle and operate in niche or emerging sectors.
Small cap indices aim to provide a broad representation of this segment by tracking the collective performance of multiple small cap stocks. Although indices track multiple stocks and remove the risk of company-specific bias, small cap investments, in general, are highly volatile. They can experience sharp declines in performance during market corrections, and their performance may improve significantly during bull phases. Nevertheless, small cap investments offer potential for wealth creation in the long run.
Read more about index funds.
Small cap mutual funds are actively managed equity schemes that are mandated by SEBI to invest at least 65% of their corpus in small cap stocks. The remaining portion may be allocated to cash, debt instruments, or stocks of other market capitalisations, depending on the fund’s strategy.
Small cap funds primarily aim to identify high-growth companies early and potentially create wealth in the long run. The active management of the fund aims to outperform the broader small cap index. However, since the companies are relatively new in the market, they are less researched and vulnerable to business-specific risks. They also have lower liquidity, as small cap stocks trade at lower volumes. As a result, fund performance can vary significantly based on market cycles, and investors are recommended to remain invested for a longer time to ride out volatility.
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Small cap index funds follow a passive investing approach, which means they aim to replicate the performance of a chosen small cap index rather than outperform it. These funds invest in the same stocks and in roughly the same proportions as the underlying index. Small cap index mutual funds may track indices such as the Nifty 250 Small Cap Index, Nifty Small Cap 100 Index, BSE Small Cap Index, etc.
The idea behind small cap index funds is to track the index and make minimal portfolio changes. Thus, the expense ratio of these small cap funds is minimal and the risk of human bias or errors is generally reduced.
Key characteristics of small cap index funds in India include:
- Market-linked returns that closely track the index
- Low expense ratios due to minimal fund management
- High diversification across many small cap companies
- No attempt to time the market or allocate assets dynamically
Nevertheless, passive investing also means that small cap index funds can have certain downturns:
- They fully participate in market downturns
- Cannot avoid weak or overvalued stocks within the index
- Do not benefit from specific stock selection during market downturns
Invest in the Bandhan Nifty Smallcap 250 Index Fund to diversify your portfolio with a passive investment option today!
Active small cap mutual funds rely on the experts to outperform the benchmark index. The investment process typically involves identifying and investing in companies that are undervalued or have the potential to grow in the long-term. The fund has the flexibility to over-represent or under-represent stocks from specific sectors and exit companies that are not performing well. While the fund is mandated to hold 65% of its assets in small cap equities, it can hold higher cash levels during uncertain market conditions.
While this flexibility is an important part of an active investment approach, it can lead to human errors and biases. The performance depends on the fund strategy, research resources, and ability to navigate market conditions.
Read about active vs passive investing in India.
One of the key differences between index funds and mutual funds is the expense ratio. The expense ratio represents the annual fee charged to manage the fund. The expense ratio is expressed as a percentage of assets under management. Over the long-run, this cost difference can have a substantial impact on returns due to compounding. While higher expense ratios may be justified if an active fund consistently outperforms the index, small-cap funds are risky, and returns are never guaranteed. This makes expense ratio a critical factor for investors when choosing between active and passive small-cap strategies.
| Parameters | Small Cap Index | Small Cap Mutual Fund |
| Definition | A benchmark tracking the performance of multiple small cap stocks | Actively managed funds investing primarily in small cap companies |
| Examples | Nifty Small Cap 250, BSE Small Cap Index | Actively managed SEBI-registered small cap schemes |
| Objective | Reflect the overall small cap market performance | Aims to generate returns higher than the benchmark |
| Management Style | Passive | Active |
| Market Timing | Does not attempt to time the market | Attempts to time the market |
| Stock-specific risk | Diversified across the index | Depends on portfolio concentration and fund strategy |
Both small cap index funds and actively managed small cap mutual funds offer exposure to the high-growth potential of small cap companies in India. Index funds provide low-cost, transparent, and predictable market-linked returns, while active funds offer the possibility of outperformance through skilled stock selection.
The choice ultimately depends on an investor’s risk tolerance, time horizon, belief in active management, and willingness to monitor fund performance over time. For many long-term investors, a combination of both approaches may be suitable.
