The small-cap sector is home to most companies and is a popular space for many active and passive investors. With a market capitalization of approximately INR 5000 crores, small-cap funds are ahead of mid-cap and large-cap funds. Increasing demand for small caps tends to lead to an increase in price and vice versa.
Most people don't invest in small-cap funds simply because they think they are riskier. After all, why risk your hard-earned money on stocks that can move up or down more than the big dogs? While it is true that small-cap funds are not for the faint of heart, investing in this type of fund can be profitable for you in the long run.
You're stumped on what mutual funds to invest in? You've decided to go with small-cap investing. Not a bad decision. Small-cap investing has its fair share of rewards. A rising tide raises all ships, and small caps tend to ride the waves quite nicely, according to the historical returns data. But then you get stuck: where do you start? How many small-cap mutual funds are there? Where do you begin?
Understanding Small Cap Funds
Small-cap funds are mutual funds that invest in smaller companies. These companies can be either private or publicly traded companies. Small-cap funds are generally less liquid than large-cap mutual funds, meaning they don't trade as frequently and can be more difficult to sell when you want to get your money out.
These types of funds invest in companies that are not the largest but are still considered small and growing fast. Investors often use these funds for diversification purposes or to build a portfolio that includes stocks of small companies with growth potential.
The downside is that small caps can be riskier than larger companies because they do not have as much cash available to meet short-term obligations, such as paying employees or making debt payments. This means that when things go wrong at a small company, it's harder for them to recover from bad news like layoffs or factory closures by raising more money from investors or creditors.
Why Small-Cap Funds Are a Good Bet?
Investors often overlook small-cap mutual funds, but they can be a good bet for those who know how to select them. The main reason why small-cap mutual funds are a good bet is that they offer higher returns than large-cap funds.
Smaller companies have higher growth potential than large companies as they are still in their early stages of development. They also have less competition, which means they can grow faster and generate more profits.
Another advantage of investing in small-cap funds is that they offer more liquidity than large-cap ones. Liquidity refers to the ease with which you can sell an investment without affecting its price. If you buy shares in a company like Apple or Google, it might take days or weeks to sell them at the same price you bought (or even higher).
On the other hand, if you invest in smaller companies, you can sell your shares within seconds at any time of day or night at any price! Small caps are often riskier than their larger counterparts, but they can also offer greater returns over the long term.
Mutual funds that track small caps may be appropriate for investors who want exposure to this asset class but do not have the time or inclination to research individual stocks independently. Small-cap funds also can be used as part of a balanced portfolio by investors who want more diversification than is typically found in large-cap funds.
Critical Parameters in Choosing the Best Small-Cap Mutual Funds
The top small-cap funds have a long-term history of beating the S&P 500. Like many other mutual funds, they are measured by their performance relative to an index. While there are many small-cap fund types, choosing the right one is essential.
Here are some critical parameters to consider when choosing a small-cap fund:
1) Risk and Return:
Small-cap funds are more volatile than their large-cap counterparts but can offer much greater returns. A good small-cap fund will have a mix of companies that produce robust earnings growth as well as others that temporary problems have beaten down.
Look for a fund with an average annual turnover rate below 50%. This means that fewer than half of its holdings are replaced each year, which gives you more time to see if your investment thesis works out. A high turnover rate means you may be buying into companies before they've proven themselves, increasing your risk profile.
2) Expense Ratio:
The expense ratio is the amount of money an investment company charges annually for managing its portfolio. This fee covers everything from trading commissions to analyst salaries and administrative costs, so lower is better — ideally less than 1%.
3) Performance:
The first thing that needs to be determined is the fund's performance. This can be done by looking at its historical performance over a while (3-5 years).
The aim here is not only to see whether it has been able to generate consistent returns but also if these returns have been better than other similar vehicles available in the market.
4) Investment Strategy:
Another critical thing to consider when choosing a small-cap mutual fund is its investment strategy. You need to find out how much of its assets are invested in stocks and how much is in bonds or cash instruments.
You also need to know about its benchmark index and how closely it tracks this index. Also, consider whether it follows an active or passive approach towards investing.
Which Are the Top 5 Small-Cap Mutual Funds?
Here is an overview of the best-performing small-capmutual funds:
| Name of the Small Cap Fund | Assets under Management (AUM) | Annual Returns (5 years) |
| 1. Quant Small Cap Fund | INR 2355 crores | 36.87% |
| 2. Nippon India Small Cap Fund | INR 22,844 crores | 28.63% |
| 3. Kotak Small Cap Fund | INR 8614 crores | 26.74% |
| 4. Axis Small Cap Fund | INR 10,992 crores | 26.51% |
| 5. ICICI Prudential Small Cap Fund | INR 4388 crores | 26.21% |
Now that you've learned about these five small-cap funds, how do you know which is best for your personal investing? The truth is, there is no one-size-fits-all answer to this question. It all depends on what type of investor you are and how you want to be set up in the future.
Once you've got a good idea of your circumstances and preferences, you can make a more informed choice about which small cap fund will work best for you.
What Are the Traits of the Top Small-Cap Funds?
The top small-cap mutual funds tend to have a low expense ratio, allowing them to deliver higher returns over time without charging higher fees and a high average return on assets (ROA) over the past five years, as seen in the table above. They tend to focus on companies with strong fundamentals, such as high margins, low debt and strong cash flows.
They also look for stocks with strong growth prospects but at reasonable valuations. The best small-cap mutual funds also tend to have low turnover, meaning they only buy and sell their holdings sometimes. The top performers tend to have certain traits in common, including:
Long-Term Focus-
The best small-cap mutual funds focus on long-term results over short-term performance. They may have up and down years, but they don't make changes based on short-term fluctuations in the market.
Strategy -
It puts a premium on research and analysis. This can include top analysts who spend a lot of time researching companies and proprietary methods for finding great investments before they become popular with other investors.
Solid Manager Tenure-
The best small-cap mutual funds are run by managers who have been at it for years and have a long track record of success.
Low Portfolio Turnover:
High turnover leads to higher transaction costs and taxes, which drag down your returns over time. Look for funds with turnover rates below 50%, preferably much lower than that (20% or less).
Wrapping Up
Small-cap stocks tend to be more volatile than their large-cap counterparts but offer greater potential returns. While they may not provide as much stability as larger companies, they can still be suitable investments if you know where to look and how to invest wisely in them.
We have shown you how to choose the best small-cap mutual fund based on category and criteria. The current scenario of growing economic opportunities with increased jobs and investments will provide ample scope for these funds to grow and give you great returns.
Frequently Asked Questions (FAQs)
What is the taxation on small-cap mutual funds?
There are two taxation criteria for small-cap mutual funds: long-term and short-term capital gains and dividend distribution gains. Long-term gains are taxed at 10% for funds saved beyond a year.
Short-term gains are taxed at 15% when saved less than a year. Since April 2020, the dividends distributed for the mutual funds have been taxed with a 10% TDS cut for amounts exceeding INR 5000.
What are the major benefits of investing in small funds?
- Income opportunity: Small caps can offer higher dividend yields than larger companies with lower payout ratios (the percentage of earnings paid out as dividends).
- Higher growth potential: Smaller companies tend to grow faster than larger companies because they have more room for expansion.
Why are small-cap funds considered riskier than large-cap funds?
Small-cap funds are riskier than large-cap funds because they're less liquid, but they also have the potential to grow faster than large-cap. Many investors choose to invest in small caps as part of their portfolios.