Have a High-Risk Appetite? Invest in Small-Cap Funds

Within the Rs 42,000 crore net inflows into broad-based equity funds, active small-cap funds were responsible for about one-fourth of the net flows.

Equity mutual funds are primarily divided into three categories: small-cap, mid-cap, and large-cap. 

Small-cap funds are equity mutual funds that invest in small-cap companies with a market capitalisation (m-cap) of less than Rs 5,000 crore. Generally, small-cap funds are known to outperform large-cap funds over the long term because of the higher growth potential of the stocks in their portfolio. 

This provides small-cap funds with the potential to provide diversification benefits along with high returns, which often surpass those of large-cap funds by a considerable margin. 

Most small-cap stocks are often avoided by large institutional investors, considering their limited liquidity. As a result, these stocks tend to rise in value based on their own merits, boosting the scope of organic price growth.

Small-cap funds have a low base and grow at a considerably high rate as compared to large-cap companies. 

As the government and private capex (capital expenditure) has been picking up pace, small companies hold the potential to increase their capacity by two or three times at a much faster pace than any larger company, considering they have a very large base. 

That is why such companies hold the potential to increase revenue at a considerably faster pace. The relative risk of small-cap is measured in terms of Beta, which relates to the fund’s volatility with respect to a benchmark index.  Small-caps have a lower beta than mid-caps with respect to Nifty 50. 

That is why incremental allocation to small-caps will not increase the relative risk of the portfolio or beta to significant levels.

The risk levels of mid-cap and small-cap funds are quite similar. However, the future return potential of small-cap is higher than the mid-cap category. This is what makes small caps appear relatively more attractive.

It is important to note that small-cap funds can be more volatile than large-cap funds in the short term. However, in the long term, the risks of large-caps and small-caps are almost similar.

Typically, small-cap funds are characterised by their focus on a single line of business and limited diversification. This is what makes small-cap funds riskier and more volatile compared to mid-cap and large-cap funds.

Market sentiments, investor emotions, and company-specific issues tend to have a direct influence on the prices of small-cap funds. Investors with a slightly higher risk appetite and a long-term approach can go in for small-cap funds as they carry a higher level of risk as compared to large-cap funds.