The small cap advantage: Why small cap mutual funds deserve your attention

Small cap companies are like saplings in an orchard – they hold the potential for abundant growth. Unlike large cap companies, which are much like matured fruit trees that have reached their peak height, small cap stocks have plenty of room to grow and flourish. And small cap mutual funds allow your investment portfolio to benefit from the promise of small cap stocks in a strategic and low-risk manner. 

Over the long term, small cap funds have outperformed large cap and mid cap funds and recognising the return potential of small cap funds, investors have been showing an increasing interest in this equity mutual fund category lately. As per the Association of Mutual Funds in India (AMFI), small cap mutual funds saw net-flows of about ₹25,800 crore over the last one year – the highest in the equity funds category. 

So, what really are small cap funds and why should you add them to your portfolio? 

Small cap funds meaning 

Small cap funds are equity mutual funds with at least 65% investment in small cap stocks. Small cap stocks are stocks of companies with a smaller market capitalisation – between ₹500 crore and ₹5,000 crore. This range can change depending on the fluctuations in the stock market but essentially, small cap companies are typically smaller and less well-known than their large cap counterparts in the industry. 

According to the Securities and Exchange Board of India (SEBI), companies ranked from the 251^st position onwards in terms of market capitalisation are categorised as small cap companies. 

The appeal of small cap funds 

Small cap companies typically tend to be in the growth and expansion phase. They usually have innovative products and business strategies and have the potential for significant expansion. Over time, as these companies grow and mature, their stock prices could increase tremendously too. Hence, this could translate into high returns for investors over the long term. 

Small cap funds have the highest return potential when compared to large cap and mid cap funds. Over the last decade, the Compounded Annualised Returns (CAGR) for small cap funds was 21%, while that for large cap and mid cap funds was 14% and 19%, respectively.

This is why small cap funds are becoming increasingly appealing to most investors who want to invest in the equity funds category to secure high returns. The returns of small cap funds across different investment horizons, including shorter periods, have also been impressive. 

In a three-year period, small cap mutual funds have offered an average return of 35.78%. Some small cap funds, like the Nippon India Small Cap Fund, have offered significantly higher returns at 42.91% during the same period. The Nippon India Small Cap Fund is also the largest small cap fund in the country based on the assets managed, which are worth ₹36,539.54 crore. 

Risk and volatility 

Like with the nature of high-return high-risk investments, small cap funds’ high return potential also comes with high risk and volatility. Small cap stocks experience wilder swings in price compared to large cap and mid cap stocks and tend to be more vulnerable to market volatility and economic downturns. In bear markets, and also during economic crises, small cap funds may suffer greater declines and pose a higher level of risk for investors. This is because they are not as well-established as large cap companies and don’t have as much financial resources to absorb the shocks.

Another risk of small cap funds is that there is always a chance of a small cap company failing since it is typically in the initial growth phase. Small cap companies can either grow and expand rapidly over time or crash and burn. Hence, small cap stocks can be a double-edged sword for investors. However, investors with a high risk appetite may still find small cap stocks an attractive investment, especially when invested through small cap mutual funds. 

Small cap mutual funds tend to hedge the risk of small cap companies as company-specific risk is minimised due to diversification. Aggressive investors may also find small cap funds attractive if they are looking to identify opportunities to invest in promising companies in the early stages. 

Diversification and portfolio benefits

Diversification is crucial to mitigate investment risks and small cap funds help add diversification to your portfolio in several ways. First, they invest in a wide range of stocks across different sectors and industries. This helps reduce portfolio risk as even if one sector underperforms, the gains in other sectors can help offset the losses. 

Second, small cap funds also add exposure to different company sizes and market caps. It’s advisable to have equity investments across large cap, mid cap, and small cap stocks as they are not all perfectly correlated. 

Third, small cap mutual funds can employ varied investment styles and strategies, such as growth, value, and dividend. This also helps reduce portfolio risks as different investment styles have distinct pros and cons and can prove to be beneficial across different market phases.

Long-term investment potential 

Since small cap funds tend to be volatile, it’s important to have a long-term investment horizon when investing in them. The longer the investment horizon, the more time your small cap fund investment has to recover from short-term market fluctuations. Additionally, it takes time for small cap companies to grow and expand and so you need to stay invested for the long term to benefit from their potential. It’s advisable to have an investment horizon of five years or more when considering small cap funds. 

Most of the well-known stocks in the global stock market today were small-cap stocks before. This includes Apple, Tesla, Infosys, and Titan. Now they are leaders in their respective industry and some of the most coveted stocks. 

Expert opinion and success stories 

Legendary investors like Warren Buffett and Peter Lynch both made strategic investments in the small cap market during their early days of investing and reaped the benefits over the long term. 

Buffett believes that small cap stocks are an excellent opportunity for retail investors and one that institutional investors can’t capitalise on due to their size constraints. Lynch, who first coined the term ‘multibagger stock’, believes that the best way to find multibaggers is to search among small cap stocks. 

In India, small cap mutual funds are leveraging the potential of small cap stocks and delivering stellar returns. 10 small cap mutual funds gave up to 42% returns in only one year, with Nippon India Small Cap fund being one of them. 

How to invest in small cap funds 

Before you invest in a small cap fund, you have to assess your risk tolerance. Only if you have a high risk tolerance and can let your money stay invested for five years or more should you consider small cap funds. 

Once you assess this and decide that you can add some exposure to small cap funds in your portfolio, go through this checklist to select the right type of small cap fund:

• Check the fund’s performance for consistency. Make sure to check its returns across one-year, three-year, and five-year periods to understand how it has performed across different market phases. 
• Compare the fund’s performance to its benchmark index as well as peer funds to see whether the fund has been underperforming, overperforming, or is in line with the industry average. 
• Check the fund’s expense ratio as this impacts your returns. For direct plans, small cap funds’ expense ratios should be below 1%. For instance, Nippon India Small Cap fund’s expense ratio for the direct plan is 0.71%. 
• Look at the fund’s top ten holdings and industry allocation to understand its portfolio and exposure to distinct small cap companies and sectors. 
• Examine the size of the fund. Small cap funds that are extremely small may present liquidity problems and may be more volatile. 

Once you have narrowed down on the small cap fund you want to invest in, you can directly invest in it online through the mutual fund house’s official website. For instance, if you want to invest in Nippon India Small Cap fund, all it takes is a few minutes to open your investment account online. You simply have to provide your personal details and bank details and choose your investment details like investment amount, mode of investment (SIP or lumpsum), etc. 

Final word 

Small cap funds hold the promise of outperformance and stellar returns and can help you build wealth over the long term. By recognising companies with immense growth potential and strategically investing in them, small cap mutual funds offer you a way to capitalise on the massive growth and expansion journey of the large cap companies of tomorrow. 

While small cap stocks can be more volatile and carry high risk, investing in them through small cap mutual funds helps hedge this risk as it is spread across several companies and industries. Additionally, professional fund managers make strategic decisions and continuously monitor the portfolio to ensure that returns are maximised, and risks are minimised. 

If your risk tolerance and investment horizon allow for it, and you want to select the kind of equity mutual funds that can deliver impressive returns, then small cap funds should be your pick.