Risk and Rewards of Small Cap Mutual Funds

What Are Small Cap Funds?

Small cap mutual funds are those funds that primarily invest in the equity of small-cap companies. To realize their full growth potential for better returns, investors need to have a long-term perspective to overcome market volatility.

According to the Securities and Exchange Board of India (SEBI), these schemes must allocate at least 80% of their assets to small-cap companies. These companies are ranked below the 250th mark in the market capitalization with an evaluation of under Rs 5,000 crores.

Some of the popular small-cap funds in India are Nippon India small cap fund, Bank of India small-cap fund, and Tata small-cap fund among others.

Risks of Investing in Small Cap Funds

Here are 3 factors that investors must beware before investing in small-cap mutual funds:

1. Sharp Price Fluctuations

There are many factors that impact the share price volatility of small-cap companies. For instance, fluctuating interest rates significantly impact the performance of small-cap funds. The rise in interest rates increases the borrowing costs for small-cap companies. This reduces the profitability and affects the stock prices.

Moreover, the limited financial resources of small-cap companies make them vulnerable to economic uncertainties caused by frequent rate changes.

2. Liquidity Concerns

Small-cap companies are less liquid than large-cap or medium-cap ones. Thus, small cap funds are more suited to those investors who have an appetite for high risks. Lower liquidity increases risks for investors especially during volatile market conditions.

3. Wide Bid-Ask Spreads

Since small-cap stocks have a lower trading volume, the bid-ask spread is often large. This factor is a disadvantage for investors as transaction costs go up.

Investors find it challenging to buy or sell shares without significantly impacting the stock price. This lowers the overall returns and adversely affects the market efficiency.

Rewards of Small Cap Funds

Here are 3 essential features of small-cap funds that make it an attractive investment instrument:

1. Easy Diversification

By including small-cap companies in their portfolios, investors can enhance their diversification. This reduces the overall risks as investments are spread across multiple sectors.

Since small-cap companies operate in emerging sectors, investors are exposed to high-growth opportunities. There are plenty of rapidly evolving companies in this economy as India is a growing economy.

2. Undervalued by Major Investment Firms

Small-cap companies are undervalued gems and often go unnoticed. With the help of skilled fund managers, investors can identify these hidden opportunities and create wealth for investors by using a small part of their capital.

They can trace high-return avenues in underrepresented sectors and invest at the right time.

3. Attractive Returns in The Long Run

Small-cap funds have generally delivered higher returns than large-cap or mid-cap funds. Owing to their rapid growth rate, these companies operate in an untapped market in an expanding Indian economy. These companies generally tend to grow bigger but at a fast rate. This benefits small cap funds.

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Conclusion

Whether an investor is investing in a large-cap fund or a small-cap fund, the purpose of investment must be very clear. While the fund allows convenient diversification and offers high returns, there are liquidity concerns and sharp price fluctuations experienced by investors. Therefore, an investor needs to be clear about his or her investment objective and then opt for small-cap funds accordingly.