What Is A Small-Cap Mutual Fund? Why It Has High Growth Potential And What Are The Risks?

A Small-Cap Mutual Fund in India is an investment instrument that invests at least 80 per cent of its total assets in small-cap companies.

According to the Securities and Exchange Board of India (Sebi), businesses that rank below 250 in terms of market capitalization are dubbed small-cap companies.

These funds offer high growth potential, generally in a short-term window. Their pace of growth accelerates in a favourable market situation but can demonstrate high volatility in rough conditions.

Of the three broad fund categories, based on their market valuation, the small-cap equity funds usually come with significant market risks, and their promise of high returns may not materialize.

Why Small-Caps Offer High Growth?

Since the small-cap funds mostly spend on the promising, agile, and high-growth smaller companies, the potential for higher returns is also greater. Small-cap businesses typically represent a growing economy. They could be small startups with an impressive market run due to new technology, service, or an idea.

Moreover, small-cap companies offer significant rewards due to the growth in share prices over time. As most small-cap companies start their stock market journey with a low share price, they provide tremendous growth potential, often surpassing their bigger cousins—the mid-caps and large-caps.

Despite their smaller size and relatively lesser market experience, small-cap companies, thus, occupy an important place in a country’s economic growth and could become the future industry leaders.

Why Are Small-Caps Funds At Higher Risks?

Small-cap firms are new and relatively inexperienced and may not endure the market pressures for long. Large businesses often swallow up their smaller rivals to retain their leadership position in a competitive market. As a result, the smaller firms could be easily acquired by a larger one even before they mature.

Additionally, small-cap companies could be prone to various ups and downs in the market, triggered by periodic changes in government policies and economic upheavals, both domestic and international.

Hence, these market vulnerabilities could put small-cap mutual funds at higher risks.

Who Should Invest In Small Cap Funds?

Those who can weather the potential losses from their investments in the stock market could explore small-cap funds. Investors could also explore small-caps for long-term growth as the smaller companies typically take time to grow and mature, and the subscribers could be part of that journey.

Many Indian companies that started young have gone on to become big. So, it could be rewarding for both short-term and long-term investors.
Although fund managers consider the risk factors involved in small-cap companies, a few things investors could also keep in mind regarding the selection of stocks or businesses.

For instance, the sound financial strength of the company is critical to sustaining itself in the market. Small-cap companies often have low cash reserves; hence, a robust liquidity reserve is essential. Besides, investors should also look at their operating margin, quality management, sales, and profits.

Factors To Consider Before Investing In Small-Cap Funds

Risk Appetite: Small-cap companies have short boom and bust cycles; hence, the small-cap funds could be more suitable for investors who have championed when to enter or exit a particular holding to maximize returns. If looking for the long term, they should wisely select the assets.

Track Record: Checking the track record is critical in a small-cap fund, especially in a bear market phase when they are most exposed to vulnerabilities. 

Investment Capital: Investors need to decide in advance how much to invest. It determines how much risk you are willing to take.

Time Horizon: It is also a critical aspect---knowing how long you want to stay invested in a particular fund.

SIP Route: Those new to the stock market should take the SIP (Systematic Investment Plan) route to reap the maximum benefit and protect from vulnerabilities. Instead of putting all your money at once, you can increase your investments periodically in the fund. This will give you enough time to decide whether you want to exit or continue.