What Is Small Cap Fund

Small-cap mutual funds are one of the most aggressive mutual funds. These mutual funds are an investment option that invests in small-cap companies, which are all the companies after the top 250 in terms of market capitalisation. Managed by professional fund managers, small-cap mutual funds invest primarily in stocks and can potentially yield higher returns than traditional investment options. However, they are considered to be riskier as smaller companies are more vulnerable to market fluctuations and economic downturns.

Investing in small-cap mutual funds can be a great way to diversify your portfolio. It is important to research its past performance, the experience of the fund manager, the expense ratio, and the risks involved before choosing a small-cap fund. Be prepared to accept the ups and downs of the market and have a long-term investment horizon.

Read on to know about small-cap mutual fund definition, small-cap mutual fund features, and how small-cap mutual fund works.

What is a small-cap mutual fund?

Small-cap mutual funds are a type of mutual fund that invests at least 65% of their assets in small-cap companies' equity and equity-related securities. These companies are ranked 251st and below in terms of market capitalisation. Small-cap funds are ideal for investors seeking long-term capital appreciation and are willing to take on higher risk due to the potential for greater volatility in smaller companies.

Small-cap funds generally have a market capitalisation of less than Rs. 5,000 crore. However, SEBI has refined the definition, categorising large-cap funds as those ranked within the top 100 companies by market cap. A key advantage of small-cap funds is their potential for higher returns, as smaller companies often have more growth opportunities than established large-cap firms.

How does a small cap mutual fund work?

Small-cap mutual funds operate by primarily investing a significant portion, typically a minimum of 65%, of their portfolios in small-cap stocks. Small-cap stocks are those associated with companies that have a smaller market capitalization, making them relatively riskier investments. However, these stocks also offer the potential for higher returns, which attracts investors willing to accept higher volatility in exchange for the prospect of positive long-term growth.

The composition of the fund's portfolio is a critical factor in the functioning of small-cap funds. Skilled fund managers carefully select small-cap stocks, with an emphasis on companies not typically found among the top 250 in terms of market capitalization. This strategy allows the fund to focus on lesser-known businesses with substantial growth potential.

Features of small-cap mutual funds

Here are some features of small-cap mutual funds:

• Focus on small-cap stocks: Small-cap mutual funds primarily invest in stocks of companies with relatively small market capitalisations, typically below a certain threshold set by the fund manager or market indices.
• Growth Potential: These funds target companies with high growth potential, aiming to capitalise on their ability to outperform broader market indices over the long term.
• Higher risk-reward profile: Small-cap stocks are often more volatile and carry higher risk compared to large-cap or mid-cap stocks. Consequently, small-cap mutual funds have a higher potential for returns but also come with increased risk.
• Diversification: To mitigate risk, small-cap mutual funds typically hold a diversified portfolio of small-cap stocks across various sectors and industries. Read more about, What is portfolio diversification.
• Active management: Due to the dynamic nature of small-cap stocks and the need for thorough research, many small-cap mutual funds are actively managed by experienced fund managers who actively select and manage the portfolio to maximise returns.
• Long-term investment horizon: Investors in small-cap mutual funds should typically have a long-term investment horizon, as these funds may experience short-term volatility but have the potential for significant growth over time.
• Liquidity concerns: Small-cap stocks may have lower liquidity compared to larger companies, which can affect the ability to buy or sell shares quickly without impacting the stock price. Fund managers need to consider liquidity when managing the portfolio.
• Potential for alpha generation: Skilled fund managers may be able to generate alpha, or excess returns, by identifying undervalued small-cap stocks that have the potential to outperform the broader market.