Mutual Funds: Want to invest in small-cap funds? Here's an expert guide

Mutual Funds: Investing in equity mutual funds has become a common practice nowadays, but many are confused about how and where to invest. Equity mutual funds are majorly divided into three categories— small cap, mid cap, and large cap. In this article, let's understand how small-cap funds work.

Small-cap funds are equity mutual funds that invest in small-cap companies with a market capitalisation of below Rs 5,000 crore.

However, according to Chethan Shenoy, Director & Head, Product & Research, Anand Rathi Wealth Limited, market regulator Securities and Exchange Board of India (SEBI) in its classification logic for mutual funds has given a ranking-based definition of small-cap funds. 

"As per the new definition, applicable from 2018, all stocks will be indexed descending on market cap. The top 100 stocks will be classified as large-cap stocks. The 101st to the 250th stocks will be classified as mid-cap stocks, and the stocks beyond the ranking of 251 will be categorised as small-cap stocks. A small-cap fund has to mandatorily invest 85 per cent of its corpus in these small-cap stocks," said Shenoy.

According to Amit Gupta, MD, Sag Infotech, many well-known companies like Britannia, Lupin, and Titan started as small caps and eventually became large caps, creating substantial wealth for investors. The future potential for smaller companies to grow and transition into mid-cap or large-cap status contributes to the high return potential of small-cap funds.

Who can invest in small-cap funds? 

Small-cap funds are suitable for investors who have a slightly higher risk appetite and a long-term approach as they carry a higher level of risk than large-cap funds. 

Shenoy suggests that those with long-term investment horizons should opt for a market cap allocation of 50:20:30 in the large-, mid-, and small-cap categories. This exposure is for the entire portfolio and not at a fund level.

Echoing similar view, Mukesh Kochar National Head of Wealth at AUM Capital said, "Ideally the investment should be 5-7 years on a minimum side. Investors who are looking to chase little higher returns but have the patience to ride the volatility with long-term investment objectives can consider these funds. One should allocate a portion of their investment surplus as an asset allocation with 10-15 per cent allocated to this space."

What can be the rewards of investing in small-cap funds?

-Small-cap funds have the potential to outperform large-cap funds over the long term due to the higher growth potential of the stocks in their portfolio.

-Investing in small-cap funds in India offers several advantages— the potential for high returns, often surpassing those of large-cap funds by a significant margin. 

-Small-cap stocks often fly under the radar of large institutional investors due to their limited liquidity. This allows these stocks to rise in value based on their own merits, increasing the chances of organic price growth.

-Investing in small-cap funds also provides diversification benefits.

-These funds have been ranked based on their performance since inception, with returns ranging from 14.56 per cent to above 55 per cent.

- Small-cap funds have a low base and grow at an extremely high rate, compared to large-cap companies. Government and private cap ex-are picking space and small companies have the potential to increase the capacity by 2x or 3x at a much faster pace than any larger company because they have a very large base. So these companies have the potential to increase revenue at a much faster pace.

Earnings Per Share growth potential chart 

Source: Anand Rathi Wealth Limited

Understanding the risk involved in small-cap funds: 

Source: Anand Rathi Wealth Limited

-Looking at the relative risk of small-cap, measured in terms of Beta (fund's volatility w.r.t benchmark index), it has a lower beta as compared to midcaps with respect to Nifty 50. 

-Hence, incremental allocation to small caps won’t increase the relative risk of the portfolio or beta significantly. 

-From the data above, we see that the risk levels of mid and small-cap funds are quite similar, whereas the future return potential of the category is higher than midcap. This makes small caps appear more attractive.

-According to experts, in the short term, small-cap funds can be more volatile than large-cap funds. However, in the long term, the risks of large caps and small caps are almost the same.

-Small-cap funds are characterised by their focus on a single line of business and limited diversification, making them riskier and more volatile compared to mid-cap and large-cap funds.

-Prices of small-cap funds can be influenced by market sentiment, investor emotions, and company-specific issues.

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