Last Updated on May 24, 2022 by Aradhana Gotur

Mutual funds are broadly divided into three main categories – equity funds, debt funds, and hybrid funds. Furthermore, each category is subdivided into different types of schemes depending on the composition of the scheme. When it comes to equity mutual funds, the main kind of segmentation comes from the market capitalization of the stocks the fund invests in. Therefore, a large cap fund invests in stocks of large companies, a mid cap fund invests in stocks of mid-cap companies and a small-cap fund invests in stocks of small cap companies. Let’s understand what is small-cap fund and how it differs from other equity-oriented funds.

What is small-cap fund?

A small-cap equity fund is an equity-oriented mutual fund scheme that invests a minimum of 65% in stocks and related securities of small-cap companies that have a market capitalization below Rs 5,000 cr. Small-cap companies are those which rank 250 and above in a compilation of stock market-listed companies based on their market capitalisation. These companies are usually those which are in their growth stages and seek aggressive expansion.  

Small-cap equity funds invest at least 65% of the corpus in select stocks of companies ranked 251 and above based on market cap Click To Tweet

Features and benefits of small-cap equity funds

Small-cap equity funds have the following features and benefits:

  • They have a high-risk profile since the stock of small-cap companies tend to fluctuate considerably when the markets are volatile.
  • Small-cap stocks also have a high return potential. In the case of market upswings, they can yield attractive returns.
  • Small-cap equity funds are liquid. You can invest in these funds and redeem them as per your need.
  • You can invest in these funds either in a lump sum or through SIPs.

How do small-cap equity funds work?

When investors invest in small-cap funds, their investment is pooled together in a single corpus. The fund manager then invests at least 65% of the corpus in stocks and securities of select listed companies that rank 251 and above on the market capitalization parameter, but show potential for growth and/or may be undervalued.

When the market value of the underlying securities increases, you stand to earn handsome returns on your investments. On the contrary, if the market value falls, you incur losses and capital erosion.

Who should invest in small-cap equity funds?

Small-cap equity funds are suitable for aggressive investors who have the appetite for a good amount of risk. Investors with a long-term investment horizon may also consider small-cap equity mutual funds since the risks generally tend to smoothen out with time, and they can enjoy potentially good returns. Many investors also invest in small-cap equity mutual funds to diversify their portfolios across securities with varying market capitalisations

As an investor, you may consider investing in small-cap funds if such funds match your risk appetite and investment strategy. 

Small-cap equity funds are suitable for investors having an appetite for high risk, a long term investment horizon and those speaking to diversify their portfolio Click To Tweet

Things to remember when investing in small-cap funds

Before you choose to invest in small-cap mutual funds, there are a few things to keep in mind.

The risks involved

Small-cap stocks, given their aggressive growth-seeking nature, are prone to high volatility risks. A small market downturn can lead to a sharp fall in the prices of such stocks. Similarly, a small upswing can bring in good returns as well. So, you should be fully aware of the investment risks before you invest in these types of funds that have a large percentage of exposure to small-cap stocks.

The charges 

Like every other mutual fund, small-cap funds also incur a Total Expense Ratio (TER) which includes the costs of managing and administering the fund. Check the TER of different small-cap equity funds before investing. Try and opt for a scheme with a low TER so that you can get maximum returns on your investments.

Moreover, there might be an exit load at the time of redemption if you exit from the scheme within the expected minimum period of investment. Check for this load as it would reduce the returns that you have earned.

Return potential

Small-cap stocks can turn multibaggers in a good market scenario, of course, also led by capturing the potential for growth aggressively by the businesses. However, you cannot avoid the risks involved. So, understand the risk-return trade-off before investing in small-cap funds.

Suitable investment horizon

Small-cap funds are suitable for investors with a medium to a long-term investment horizon. This is because, with time, the market volatility reduces and small-cap stocks can offer attractive returns if an investor can give it the time to grow. So, assess your investment horizon too before investing in small-cap funds. If you have a short-term horizon, the risks may outweigh your potential for returns.

Peer comparison

Most mutual fund houses offer small-cap equity mutual funds. A comparison of different funds is necessary to pick the right scheme. Compare the historic returns of different small-cap equity mutual funds. Then select a scheme that has offered the highest returns, consistently, over the different time periods.

Taxation of small-cap equity funds

Investment into small-cap equity mutual funds does not provide any tax benefit. They form a part of your taxable income. However, at the time of redemption, the returns earned are subject to equity taxation. Here’s how you would be taxed on the returns earned from small-cap funds:

  • If you redeem the fund within 12 mth, short-term capital gains tax would be applicable on the returns. The returns earned would be taxed at 15%.
  • If, on the other hand, you redeem the fund after 12 mth of investment, long-term capital gains tax would be applicable. Returns up to Rs 1 lakh would be exempted from tax. If the returns exceed Rs 1 lakh, the excess returns would be taxed at 10%.

Small-cap funds are equity-oriented mutual fund schemes with a high risk-return profile. Know what is small-cap fund and understand the aforementioned aspects of the scheme. Investors may diversify their portfolio with small-cap funds, but choose to invest in the scheme only if your investment goals align with the scheme’s features. Compare before investing and also keep the tax implication in mind when you redeem the scheme.

Aradhana Gotur