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The market capitalization of companies is a key component of Equity Mutual Funds. Before investing in small cap mutual funds, it is important to understand the concept of market capitalization. It is the valuation of the company at which it is traded in the stock exchange. You can calculate a company’s market cap by simply multiplying its present share price by the total number of outstanding shares.

Market cap helps investors determine the returns and risk from a share. The categorization of mutual fund schemes is done on the basis of the market cap of the companies. They are large-cap, mid-cap, small-cap, and multi-cap schemes.

In this article, let’s take a look at Small Cap Mutual Funds.

These are funds that invest in the smallest companies in India, which may not be the most popular ones. They may pick any company apart from the top 250 companies of the market. While you might have not heard of these companies in routine life, they have the potential to deliver good returns. Small-cap companies are volatile and are suitable investment options mostly for aggressive investors.

What are Small-Cap Mutual Funds?

Small Cap Mutual Funds invest their corpus in companies with small market capitalization. The Securities and Exchange Board of India (SEBI) ranks all companies below the 250th rank as small-cap companies. The ranking is done in accordance with the market capitalization of each company. Small-cap companies have a market capitalization of less than Rs. 500 crores.

SEBI also mandates small-cap mutual fund schemes to invest at least 80% of their total assets in these companies. The mutual fund scheme can invest in either equity or equity-related instruments of small-cap companies. These funds are highly volatile and involve a high level of risk. Even the slightest volatility in the market impacts the share prices of small-cap companies. However, these stocks also offer investors higher returns as the company grows. You can understand this simply that the share price of a small company would increase as it grows.

Most investors select small-cap schemes for short-term investment needs. This may not be a great idea as small companies need time to grow. Hence, you may opt for small-cap funds depending on your risk tolerance and investment horizon. Ideally, your risk appetite should be higher and investment tenure must be longer.

Advantages of Investing in Small-Cap Funds

You get the following advantages upon investing in Small Cap Mutual Funds:

Higher growth potential: Small-cap funds have high growth potential as they invest in new companies with a greater scope of expansion. These companies have a greater ability to scale their operations compared to larger companies.

Undervalued investments: Small-cap companies are under-reported as most of them are undiscovered. As a result, they have very little analyst coverage. There is a high probability of them being undervalued and therefore, small-cap mutual funds are a good investment opportunity. They are suitable for those investors who are comfortable with much higher risk levels as seen in such companies.

Diversification benefits: Adding small-cap funds to your overall portfolio helps you to balance the risk-return trade-off. Consequently, you can diversify your investments through these funds, thereby reducing your overall risk.

Merger and acquisition possibility: The likelihood of merger and acquisition is greater with small-cap companies. They may get acquired or merge with their larger counterparts to grow inorganically. As a result, the share price of smaller companies may rise, eventually adding value to small-cap funds.

Low liquidity: Small-cap companies are thinly traded in the stock market. Although some investors consider this a drawback. It is actually advantageous for investors who foresee the potential of the company. Once the company’s earnings and revenue are made visible by the management there may be a large number of investors chasing its shares. As a result of high demand and limited availability of publicly traded shares, the prices rise rapidly.

Limitations of Investing in Small Cap Funds

You must keep in mind the following limitations of investing in Small-Cap Funds:

1. High-Risk Factor: Small-cap companies are more prone to risks. Mostly, they are not able to survive a financial crunch or economic downturn. Many small-cap companies run out of business while trying to survive against their competitors. The value of small-cap funds investing in such companies can also go down drastically. Therefore, they are not a suitable investment option for risk-averse investors.

2. Timing of investment: The timing of buying or redeeming the small-cap mutual fund is controlled by market volatility. The ups and downs of the market can make or break a small-cap fund within a short period.

3. Highly volatile: Stocks of small-cap companies are impacted when the market sentiment turns weak. Small-cap schemes tend to bleed during volatile markets. The volatility of stock prices of small-cap companies is greater during such times.

4. Do not pay dividends: Small-cap companies are young and generally do not pay dividends. As they need to grow their business, they tend to reinvest their earnings into it. Thus, you cannot rely on small-cap funds as a source of income from dividends.

5. Research is needed: Owing to a large number of small-cap companies there are hundreds of different small-cap funds. It is difficult to find out which one will grow your investment or which one will not give appropriate returns. You must conduct proper research to select the right small-cap fund and identify the ones with the best investment potential.

Who Should Invest in Small Cap Funds?

Small-cap mutual funds are driven by the volatility of small-cap companies. They are ideal for investors who are ready to take higher risk for the potentially higher upside. You should think of investing in small-cap mutual funds only if you have a larger risk appetite. Remember that when the market is down, your returns may be significantly low. You should take into account the aggressive financial expansion of small-cap companies. It makes the share prices of these companies more volatile and vulnerable to losses during a market downfall.

Experts advise diversifying your portfolio to avoid losing all your money at a time. Therefore, you must invest carefully and include small as well as mid cap funds in your basket. It offers you safety if your small-cap funds do not work out. Even most of the small-cap fund schemes invest up to 80% to 90% in small-cap companies. Their remaining investments are in mid-cap companies.

You must identify the best small-cap funds and dedicate a small portion of your investment portfolio to them.

How to evaluate small-cap mutual funds?

1. Sharpe Ratio

Sharpe ratio is considered as a very popular method for measuring risk-adjusted returns.

Sharpe ratio = (return on investment – risk-free return)/standard deviation of the investment

The higher the Sharpe ratio, the better it is because the portfolio has given much better returns compared to the risk. In simple terms, it shows how well the returns of the asset has compensated for the risk taken.

2. Treynor Ratio

The Treynor ratio measures the excess return earned above the risk-free investment. It determines how much excess return was generated for each unit of risk taken by the portfolio.

Treynor Ratio = (return of the portfolio – risk-free return)/beta of the portfolio

The Sharpe ratio helps investors understand an investment‘s return compared to its risk while the Treynor ratio explores the excess return generated for each unit of risk in a portfolio.

3. Jensen Alpha

Simply put, Jensen alpha is the difference between the actual return earned vs the overall benchmark return. It measures the ability of the fund manager to increase the returns above the benchmark. It is considered useful only when comparing 2 portfolios with the same beta.

Things To Consider for Investing in Small Cap Mutual Funds

Small-cap mutual funds are vulnerable to risks in the market. It is recommended that investors look at the risk they are willing to take before investing in small-cap funds. You must consider your investment goals along with all the factors that influence the performance of these funds.

Following are the things to consider before investing in the best small-cap funds:

Investment risks 

It has been seen that even the best small-cap mutual funds are exposed to a significant amount of risk. But some funds offer fruitful returns. These are higher than the risk involved. You should look for funds that have performed better than other small-cap funds to pick the best one for your portfolio. Also, consider looking at the Small Cap benchmark and pick the funds that have performed better than it. It helps you make sure that you are getting good returns and taking a lesser risk.

Investment return

Returns on small-cap mutual funds are usually high but they involve a greater risk as well. Though they can be a great addition to your portfolio you must pick them wisely. Ensure that the funds you pick also act as buffers in your portfolio. They must provide high value if things work out in the market as you are taking a significant risk.

Investment cost

Small-cap equity funds come with an investment expense known as the expense ratio of a fund. The expense is applied by the fund house for managing your investment. The fund house calculates the expense ratio as per the guidelines laid out by SEBI. The guidelines limit them to keep the expense ratio of a fund at 2.50%. You should look at net return post expense. This will help you consider your investment cost while shortlisting a fund.

Investment goals 

Even the top small-cap mutual funds can perform poorly when the market starts falling. They may face significant erosion in their returns. Hence, you should invest for a longer term to make the most out of your investment. Pick a goal that you might want to fulfill in the coming 7-10 years when investing in a small-cap fund. So, it is advisable to invest in these funds for meeting goals such as the education of your children, buying a home, or saving for post-retirement life.


Investors must pay taxes on capital gains earned on small-cap equity funds. These taxes are payable at the time of redeeming the funds. The calculation of taxes depends on the investment period in the funds. This is the total duration for which you were invested in the mutual fund. It is also known as the holding period of the fund.

These Capital gains may be of two types:

1. Short Term Capital Gains (STCG): These are Capital gains from the redemption of funds with a holding period of up to one year. The tax on STCG is levied at 15%.

2. Long Term Capital Gains (LTCG): The capital gains from funds with a holding period of more than one year. The tax on these is calculated at 10% if the amount exceeds one lakh. Tax is applicable only on the amount exceeding one lakh. Any amount less than one lakh is not included in the tax calculation.

Another tax applicable on small-cap mutual funds returns is Dividend Distribution Tax (DDT). It applies to you if you are investing in a dividend variant of the fund. It applies to any dividend you receive during the holding period. The fund house will deduct a DDT of 10% before paying out the dividend applicable to your investment.


You can diversify your portfolio with small cap mutual funds. You must analyze your long-term financial needs before investing in these schemes. But you must do proper research about the fund before investing. Consider all factors these funds involve high-risk.

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