Points to Consider Before Investing in Small Cap Mutual Funds

Risk and Volatility

Small cap funds are considered a high-risk investment and are subject to various types of investment risks. They are vulnerable to market volatility and fluctuations and can experience sharp declines in prices during market downturns. As compared to large and mid-cap funds, the performance of small cap funds fluctuates more. This is because the scheme primarily invests in stocks of small cap companies, which may have minimal financial backing and are more vulnerable to market downturns. During recessions or economic slowdowns, the underperformance of small cap funds may be greatly exaggerated; however, when the market is bullish, the performance of small cap funds may be better than large cap funds and mid cap funds. Thus, before investing, investors must consider the following:

• Whether they can remain invested throughout market cycles
• Whether they have a long-term investment horizon of at least 5-7 years
• Whether they can withstand short term volatility and fluctuations
• Whether they have a high-risk appetite

Long-Term Investment Horizon

Small cap mutual funds are generally suited for investors with a long-term investment horizon. This is because a longer investment horizon may allow them to ride out short-term volatility and potentially create wealth. Generally, the investment period is 5-10 years; however, investors may remain invested for longer based on market conditions. Short-term investing in small cap funds may lead to capital erosion during downturns, and if investors are compelled to exit during slowdowns, they may experience losses. Moreover, small cap funds are subject to liquidity risk as small cap stocks are relatively illiquid. They trade at lower volumes, and exiting the investment in a rush can lead to losses. Thus, investors must:

• Evaluate their investment horizon
• Be able to withstand liquidity risk
• Remain invested for a long time (5-10 years or more)

Learn more: Long-term investment options in India!

Liquidity Risk

Small cap stocks trade at lower volumes as the companies are smaller. Exiting or entering the market can be difficult, especially during market slowdowns. Thus, small cap funds may be a suitable part of a diversified portfolio; however, as an individual investment, they may pose liquidity risk to investors. Before investing in small cap funds, investors must:

• Consider if they can withstand illiquidity or losses due to it
• Remain invested for a longer time to avoid liquidity risk

Small Cap Fund Performance 

The performance of actively managed small cap funds largely depends on the fund strategy and portfolio allocation. Investors must analyse the small cap fund before investing in it by looking at factors such as the expense ratio, portfolio composition, fund performance, fund track record, and performance consistency across market cycles. Since small cap stocks are more volatile, returns are significantly dependent on the fund’s strategy and ability to read the market. Investors must therefore:

• Evaluate small cap fund performance based on recent and risk-adjusted performance
• The fund’s ability to navigate different market environments 
• Evaluate the fund’s strategy and asset allocation

Expense Ratio and Costs

The expense ratio of a small cap fund is a crucial factor to consider before investing. The expense ratio refers to the annual fee charged by a mutual fund to manage and operate the fund. It is expressed as a percentage of its assets under management. Small cap funds are actively managed and may thus have a higher expense ratio. Over time, the expense ratio can reduce the overall returns of the fund, significantly impacting long-term returns due to the effects of compounding. Thus, investors must:

• Check the expense ratio before investing
• Analyse whether it aligns with their investment strategy and portfolio

Market Cycles

Market cycles can exaggerate the performance of small cap funds. The fund has a tendency to outperform in bull markets, potentially increasing returns and creating wealth in the long run. However, during market downturns, recessions or sideways markets, the performance of the small cap fund declines significantly. As a result, the performance of small cap funds is volatile and varies, and investors must be able to remain invested throughout market cycles to potentially avoid losses. Thus, investors should:

• Analyse the market conditions they are entering the investment in
• Analyse the market conditions they are exiting in
• Stay invested for a longer time
• Consider consulting a financial advisor for personalised financial advice that meets their portfolio needs

Portfolio Allocation

Investors must consider their overall portfolio allocation and allocation to risky assets. This is because small cap funds are an inherently risky investment. Diversifying the portfolio may enable them to mitigate some risk and reduce overall losses. 

Although small cap funds have a high-risk appetite, they have the potential to generate wealth in the long-run, especially if they are included as a part of a diversified investment portfolio. Analysing a small cap fund correctly by considering its relevance to your portfolio and risk appetite is essential. 

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