Do small-cap funds make for a good investment?

Equity investments are known for their volatility and potential to provide you higher returns. Although unpredictable, equity investments have considerably greater potential to appreciate your capital relative to other investment options. However, they carry higher risk as well.

If you are an investor who can stomach this risk and want to make the best out of the aggressive nature of the equity market, you could consider investing in small-cap funds.
The characteristics of these funds are similar to those of small-cap companies, but investing in small-cap funds is easier than investing in small-cap companies. Let us learn more about small-cap funds and check whether they serve as a good investment option.

What is a small-cap company?

Companies are divided into three categories on the basis of their market capitalization by the Securities and Exchange Board of India (SEBI). The top 100 listed companies in India are considered large-cap companies in terms of their market cap. The companies with ranks 101 to 250 are considered mid-cap companies. The rest of the companies listed in India are considered small-cap companies.

Large-cap companies are known for their stability. They are mostly market leaders. They have a strong foundation, and their stock performance is expected to be stable in most cases. This makes them comparatively safer investment options among equities.

Mid-cap companies are not as large as large-cap companies, but they are nonetheless considered big. Because there are almost 150 mid-cap companies, their characteristics may vary according to their rank. For instance, the company ranked 101 may be more stable than that ranked 250. Even then, they mid-cap companies tend to be less stable than large-cap companies.

Small-cap companies are typically viewed as riskier than large- and mid-cap companies because they are typically less established and have less access to capital. However, they have the potential for greater growth because they tend to be in an earlier stage of development and have more room to grow.

What are small-cap funds?

Small-cap funds are mutual funds that invest in small-cap companies. Therefore, they tend to share the characteristics of small-cap companies. A few advantages of investing in small-cap companies are as follows.

1. Higher potential for growth

Large-cap companies don't have much room to expand. Their exponential growth in the past may have capped their potential for further share price growth. However, a smaller company may still have many years of growth and stock price appreciation ahead of it.

This means that you can get in on the ground floor of a rapidly growing company when you invest in a small-cap fund. If the company expands and its share price rises, your decision to buy and hold its shares early on may turn out to be wise. Moreover, the company may successfully transition from a small cap to a large cap in the future.

2. Potential for growth
Stability and dividends are characteristics of large-cap companies. While small caps may not pay dividends, they have a proven track record of outperforming their larger counterparts in annual returns.

Source : https://www.livemint.com/Opinion/K46p0zCU72Bn2QAFh1eXXK/Both-large-and-smallcap-mutual-funds-give-high-returns.html

Smaller businesses have more room to expand than their larger counterparts. Moreover, they may be able to better respond to market fluctuations, create and introduce new products, and reorganize internally. These factors explain why small caps may often outperform their larger rivals in specific markets.

Small-cap funds have some downsides too as below.

1. Volatility

Owing to their shorter histories, smaller companies are more susceptible to market fluctuations than their larger counterparts. In addition, because of factors such as limited access to capital and the need for further development of a business model, a smaller company's stock price may be more volatile than that of a larger one. Be aware of this if you do not have the patience to wait out significant price fluctuations.

2. Lack of data

You should do your research and grasp a company's basics before investing your money in its stock. Typically, less data is available for small caps, which makes it more difficult to arrive at educated investment decisions. For instance, you may lack access to earnings reports or pricing trends spanning multiple decades. It might be more difficult to gauge the potential of a small-cap company if this is true.

Conclusion

Whether small-cap funds are a good investment or not depends on the type of investor you are. For example, if you are an investor who can stomach the higher risk and are seeking aggressive investment options, small-cap funds may be the right fit. They use the stock market’s volatility, which is a double-edged sword, to grow your capital when markets are doing well, but they may take a sharp hit when market conditions are bad. Hence, the primary determinant of whether small-cap mutual funds are a good investment for you is your risk tolerance. However, investing in small-cap stocks through mutual funds tends to lower this risk owing to the diversification offered by mutual funds.

Note: Small Cap:251st company onwards in terms of full market capitalization

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