Are Small-Cap Funds the Right Investment Option?

Are you looking for an investment that offers an inflation-beating return? Do you want to invest in small companies with high growth potential? You may consider putting money in small-cap funds. According to SEBI re-categorisation, small-cap funds invest in companies below the top 250 stocks on the exchange in terms of market capitalisation.

You have the Nifty Smallcap 100 TRI, the benchmark index for small-cap funds, delivering a stellar performance of 114% over one year as of May 03, 2021. However, small-cap funds are more volatile than other equity-oriented funds despite the potential for higher returns. Should you invest in small-cap funds?

What are small-cap funds?

Small-cap funds are a type of equity mutual fund that invests predominantly in companies with a market capitalisation below Rs 5,000 crore. The fund manager invests in smaller companies that focus on newer business models and can become giant firms over time. 

According to SEBI rules, small-cap funds must invest a minimum of 65% of the total assets in small-cap stocks. As per AMFI data, small-cap funds saw a massive increase in total funds from 1,711 crore in April 2021 to 2,316 crore as of May 2021. 

Should you invest in small-cap funds?

You have many investors looking to invest in small-cap funds after 17 out of 24 small-cap schemes delivered returns above 100% in just one year. However, it’s essential to realise that past performance doesn’t mean the mutual fund would do well in the future. 

You may invest in small-cap funds if you are an aggressive investor who understands the stock market. However, you must know when to exit your investment as small-cap funds are not suitable for buy-and-hold investors. 

You have small-cap funds performing exceptionally well during a bull market. However, small-cap funds could crash steeply in a bear market. For instance, several small-cap funds crashed heavily in 2018 and 2019. 

You may avoid investing in small-cap funds if this is your first time in the stock market. Moreover, market savvy investors could allocate a small portion of their portfolio of around 5%-10% towards small-cap funds to enhance the overall portfolio return. 

You may invest in equity funds through the systematic investment plan or SIP to avoid timing the stock market. It is a way of investing small amounts regularly in a mutual fund scheme to average out the purchase price of units over time. 

However, SIP doesn’t work for small-cap funds as you have to time the market to maximise your return. You may consider purchasing small-cap funds when the stock market is bottoming out and sell units when the bull market is peaking for maximum returns. 

How to select the right small-cap funds?

You must check the track record of small-cap funds across both the bull and bear markets. It helps if you pay close attention to the performance of small-cap funds during bear markets to gauge the downside protection during stock market falls. 

You may consider checking the performance of small-cap funds over three to five years. The small-cap space has short boom and bust cycles, and it helps if you study the performance of small-cap funds over a longer time.

You can opt for small-cap funds with a lower expense ratio to increase your take-home return. It is the cost of managing your investment, and a higher expense ratio would eat up your returns. 

You may avoid investing in small-cap funds that have large assets under management (AUM). It is difficult for fund managers to find adequate investment opportunities, volume and quantity in the small-cap space, leading to managing a huge fund. 

Small-cap funds are suitable for sophisticated investors who understand the stock market. However, merely tracking small-cap funds for three to five years is not enough. You must understand the small-cap space and invest in small-cap funds, which you are comfortable holding even in a bear market. In a nutshell, small-cap funds are suitable for market-savvy investors who know when to exit the investment.

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