What are small cap mutual funds?

Investing in mutual funds has now become simpler than ever. Where once investing meant putting your money in the stock market, which can be disorienting owing to the hundreds of options available and regular fluctuations, now, with the popularity of mutual funds, investing your money has become as simple as clicking a button on your smartphone.

However, this does not mean that you absolutely do not have to put any thought into selecting the type of mutual fund that you’re investing in. Depending on your own expectation of risk vs. reward, there is one main consideration to take into account when you invest in mutual funds. And that is called market cap.

Market cap or market capitalization, is the market value of a publicly traded company. All companies on the stock market are categorized into three main groups. Small cap, mid cap and large cap. So based on the valuation of a company, they can either be a small cap company, a mid cap one, or a small cap one. This article will be focusing mainly on the small cap company.

Small cap mutual funds are funds that invest entirely in small cap companies. But what defines a small cap company? In terms of valuation, any company that has a market capitalization of Rs. 500 crores or less can be termed as a small cap company. These are the companies that are relatively smaller now but are looking to expand aggressively. This means that small cap mutual funds have excellent potential to generate greater returns.

Small cap mutual funds are generally preferred by individual investors to beat out institutional investors. Since institutional investors look for long term stability, they prefer mid-cap or large cap funds for investment. Individuals, however, prefer aggressive returns over stability and they can achieve that with small cap mutual funds.

If you’re someone who has the ability to take higher risks with your investment, then yes,small cap funds can be beneficial for you. However, you should do so with the clear knowledge that precisely because of the aggressive financial expansion of small cap companies, they’re bound to be more volatile and vulnerable to losses when the market is down.

It is always advised to not put all your money in one basket, or you may lose it all. Invest carefully in a diverse portfolio that has both small as well as mid cap funds so that you have a safety net if your small cap funds do not work out. Most small cap funds invest about 80% to 90% in small cap companies and the rest in mid cap companies.

Before investing in small cap mutual funds, here are a few things that you must keep in mind.

• Risk vs. return

  As discussed previously, small cap mutual funds have a much higher risk but on the other hand, they also can give you handsome returns. Seasoned investors with a higher risk profile are most suitable for small cap mutual funds.

• Expense ratio

  The expense ratio is a small fee charged by the asset management company that allocates your funds. In the case of small cap funds, this expense ratio can be higher. The Securities and Exchange Board of India has set a limit for 2.5% for expense ratio. It is important to keep in mind the expense ratio before zeroing in on a small cap fund since it may eat into your returns.

Advantages of small cap mutual funds

• Exponential growth potential

  Small cap funds can have exponential growth potential because a small company with the right idea and expansion plan can suddenly shoot up when no one is expecting it.

• They’re mostly ignored by institutional investors

  Small cap funds are mostly untapped by institutional investors and therefore, individual investors have the opportunity to invest in them and grow their investment considerably.

• They can be the dark horse of a diverse portfolio

  It can happen that you have a diverse portfolio that has large cap, mid cap and small cap funds; and when the other funds aren’t performing too well, your small cap funds may be the saving grace and can potentially give good returns to keep your portfolio balanced.

Disadvantages of Small cap funds

• High risk factor

  By now it is quite clear that small cap funds can be risky if an investor is not very careful. If the small cap company goes out of business, the investor may lose their investment.

• Timing of investment

  The timing of buying the small cap mutual fund and redeeming it is extremely important because volatile markets can make or break a small cap fund within a short span of time.

• Research is very important.

  There are hundreds of different small cap funds and you never know which one will grow your investment and which one will reduce it. So proper research is important to select a small cap fund that has better potential.

Thus, small cap mutual funds must be chosen wisely, keeping all the above factors in mind. The best way is to keep a balanced portfolio that will provide a safety net in case your small cap funds fall short. Invest wisely and you can reap the rewards.