Small-cap mutual funds: Big potential, bigger risks
Small-cap stocks are typically defined as companies with a market capitalization of less than Rs 5,000 crore. Small-cap mutual funds invest primarily in these small companies. These companies present a unique opportunity for growth. Read more to find out about the risk and return potential of small-cap mutual funds.
Risk and return potential of small-cap funds
Small-cap stocks are often considered more risky than large companies but they also offer the potential for higher returns over the long run. This is because small companies tend to have more room for fast growth compared to established large companies. However, with higher potential reward comes higher risk. Small companies are more volatile and sensitive to market fluctuations. They tend to underperform large caps during market downturns but can outperform during bull runs.
For investors in India, small-cap funds provide an opportunity to invest in up-and-coming companies that could become the blue chips of tomorrow. Over the past 5 and 10 years, small-cap funds in India have generated average annual returns of around 15-20% compared to around 10-13% for large-cap funds. Some of the top-performing small-cap funds in India have delivered 20-30% annual returns over the long term.
However, the last few years have been difficult for small-cap funds. The category saw deep losses in 2018 due to a combination of expensive valuations, liquidity issues, and corporate governance problems in some companies. The funds have bounced back strongly this year but the volatility serves as a reminder of the risks. Investors need to go into small-cap funds with realistic expectations of periodic underperformance and be willing to remain invested for the long haul.
Things to keep in mind while investing in small cap funds
- Focus on the long term
Small-cap funds should be held for at least 5-7 years to ride out market ups and downs. Don’t invest the money that you need in the short term.
Choose a mutual fund that invests in 50-100 companies across various sectors. This reduces risk. Sector-specific small-cap funds tend to be riskier.
- Check the portfolio
Look at the fund’s top holdings and sector allocations to make sure you are comfortable with the level of risk. More speculative companies and sectors increase volatility.
- Evaluate costs
Small-cap funds typically charge higher fees. Look for a fund with reasonable fees relative to its benchmark and peers. Lower fees mean more of your money is working for you.
- Review performance
Compare the fund’s returns over 3 years and longer versus its benchmark and category peers. Look for consistency in outperformance, not just one year of good returns.
- Consider passive funds
Index-based small-cap ETFs and index funds provide broad market exposure with lower fees. They can be a simpler option than actively managed funds.
While small-cap funds offer the potential for exciting returns, investors need to go in with their eyes open to the risks. By following the tips above and maintaining realistic expectations, small-cap funds can play an important role in a well-diversified investment portfolio.