Small-Cap Funds: When To Invest And Why

Small-cap funds are a popular investment option due to their high returns. They invest in companies that are below the top 250 stocks in the exchange in terms of market capitalization. Small-cap funds are considered riskier and more volatile than other equity-oriented funds in the short to medium term, but they promise higher returns in the long term. They are suitable for investors with a high-risk appetite and a long time horizon. Small-cap funds have the potential to provide significantly higher returns than mid-cap or large-cap funds due to the strong growth potential of small-cap companies. However, their prices can also fluctuate dramatically, making them risky investments.

Higher growth potential

Small-cap funds are a popular investment option due to their high-growth potential and higher returns compared to large-cap funds. They invest in small-cap companies, typically in their early stages of business, which have a lot of scope for growth. As these companies grow, the value of their stock prices increases, leading to higher returns for investors.

Small-cap funds are defined as those that invest in companies ranked beyond the top 250 in terms of market capitalization. These companies have a market capitalization ranging from $250 million to $2 billion, with a potential to grow into big-cap stocks.

Small-cap funds can be a great addition to an investment portfolio, offering diversification and the potential for rapid growth. They are suitable for investors with a high-risk appetite and a long-term investment horizon. However, it is important to note that these funds are highly volatile and carry a high level of risk. They are sensitive to market movements and can be significantly affected by a market downfall.

To maximize the potential of small-cap funds, investors should consider the following:

• Investment risks: Evaluate the performance of different funds to identify those that offer good returns with lower risk.
• Investment return: Small-cap funds tend to yield high returns, but it is important to consider the associated risks.
• Investment cost: Consider the expense ratio, which is the annual fee charged by the asset management company, as it can impact your overall returns.
• Investment goals: Small-cap funds are suitable for long-term investment goals, typically ranging from 7 to 10 years.
• Taxation: Capital gains tax and Dividend Distribution Tax (DDT) apply to returns on small-cap funds, depending on the holding period.

Higher volatility

Small-cap funds are considered to be the most volatile among all equity funds. This means that they can deliver huge returns, but also that they are susceptible to abrupt falls in value.

Small-cap funds are shares of smaller companies, typically valued between $300 million and $2 billion. They are considered riskier than large-cap stocks because they are more vulnerable to recessions, market crashes, and other economic shocks. For example, during the 2020 stock market crash, small-cap stocks fell more than their large-cap peers.

Due to their higher volatility, small-cap stocks tend to outperform during young bull markets when stocks are moving higher. However, they can also be significantly impacted by downturns in the market. For example, after a strong year in 2017, the NSE Small Cap 250 index lagged the returns of large-cap and mid-cap indices in 2018 and 2019.

Small-cap stocks are also followed by fewer investors and analysts, so they often experience bigger swings in response to news and earnings reports. This makes them attractive to active traders like day traders.

Despite the risks, small-cap funds can be a good investment option due to their high growth potential. They are suitable for investors with a high-risk tolerance and a long time horizon, typically at least seven years.

Lower interest rates

However, it is important to remember that small-cap stocks are also more volatile than large-cap stocks due to their vulnerability to recessions, market crashes, and other economic shocks. For example, during the 2020 pandemic-driven market crash, small-cap stocks fell more than their large-cap peers. Therefore, lower interest rates alone may not be sufficient to make small-cap funds a good investment; other factors, such as the broader economic climate and your risk tolerance, should also be considered.

Bull markets

Investing in small-cap funds during a bull market can be a strategic move, but it's important to approach it with caution and a long-term perspective. Here are some key considerations for investing in small-cap funds during a bull market:

• Understanding Bull Markets: A bull market is characterised by rising stock prices and general investor optimism. It is typically defined by a sustained increase in share prices over an extended period, usually lasting for months or years. During a bull market, investor confidence is high, and there is an overall positive sentiment in the market.
• Volatility and Risk: Small-cap funds tend to be more volatile than large-cap funds, and this volatility can be amplified during a bull market. While small-cap stocks can offer significant growth potential, they also carry higher risks. It's important to assess your risk tolerance and ensure that you are comfortable with the potential for larger price swings.
• Diversification: To manage risk effectively, diversification is crucial. Diversifying your portfolio across various sectors and industries can help reduce the impact of any single investment on your overall returns. Consider investing in a range of small-cap funds from different sectors to spread your risk.
• Long-Term Investment Horizon: Investing in small-cap funds during a bull market should ideally be approached as a long-term strategy. Small-cap stocks tend to be more sensitive to market changes, and their performance can be more volatile in the short term. By adopting a long-term investment horizon, you can ride out short-term fluctuations and focus on the potential for long-term growth.
• Fundamentals and Valuation: During a bull market, it's crucial to focus on the fundamentals of the companies in which you're investing. Assess the financial health, growth prospects, and valuation metrics of small-cap companies before investing. Avoid investing solely based on market momentum, and ensure that the companies have solid business models and strong competitive advantages.
• Entry and Exit Points: While timing the market precisely is challenging, it's important to consider your entry and exit points during a bull market. Avoid investing at market peaks, and look for opportunities to enter at relatively lower valuations. Similarly, be prepared to exit your small-cap fund investments if the bull market shows signs of reversing or if the valuations become excessively stretched.
• Risk Management Strategies: Consider implementing risk management strategies, such as setting stop-loss orders or using dollar-cost averaging. These strategies can help you limit potential losses and protect your profits during a bull market.
• Regular Monitoring: Stay informed about market trends, economic conditions, and the performance of your small-cap fund investments. Regularly review your portfolio to ensure that it aligns with your investment goals and risk tolerance. Be prepared to make adjustments as necessary to manage your risk and optimise your returns.

In summary, investing in small-cap funds during a bull market requires a careful assessment of your risk tolerance, a long-term perspective, a focus on fundamentals, and effective risk management strategies. Remember that bull markets don't last forever, and it's important to be prepared for potential market corrections or downturns.

Long-term investment

Small-cap funds are a great way to boost your overall investment performance over time. They are a good choice for long-term investments as they tend to perform well over a long period.

Small-cap funds invest in companies with a market capitalization of a few hundred million dollars to a few billion dollars. They have a higher growth potential compared to large-cap funds as they are younger firms bringing new products and services to the market or creating entirely new markets.

Small-cap funds are also a good way to diversify your portfolio. They can be a suitable portfolio inclusion if large-cap and mid-cap funds are not delivering returns as per expectations. They tend to offer better gains, thus balancing your portfolio.

However, small-cap funds are very risky and volatile in nature. They are suitable for investors who are already in the investment market and are looking for ways to diversify their investments. They are also suitable for investors with a high-risk appetite and those who can stay invested in the funds for the long term.

Small-cap funds are best suited for investors with a good understanding of mutual fund investments. They are not recommended for new investors or those investing for a short duration.

When deciding whether to invest in small-cap funds, it is important to consider the following factors:

• Risk factor: Small-cap funds are highly volatile compared to mid or large-cap funds.
• Investor expertise: Small-cap funds require a good investment strategy and observation. They are best suited for investors with good mutual fund investment expertise.
• Investment term: Small-cap funds are most suitable for investors with a long investment time horizon and are usually not suitable for short-term investors.

In conclusion, small-cap funds can be a great choice for long-term investments, offering high growth potential and diversification. However, they come with higher risks and volatility, so it is important to carefully consider your investment goals and expertise before investing in them.

Frequently asked questions