Small-cap Equity as an investment

Aug 11, 2022

Small-cap Equity as an investment

Small-cap funds are necessarily equity funds that allocate a major section of the funds to small company stocks. The Securities and Exchange Board of India (SEBI) lays down the list of top companies as well as the norms for the investment portfolio of different kinds of funds. Small-cap stocks are the ones that are beyond the top 250 companies in the SEBI list and are often unheard of. Fund managers look out for such small-capitalization stocks that are constantly performing in the market and sometimes outperforming the benchmark indices and large-cap stocks. They invest in such stocks that have the capacity to be big businesses in the future and deliver good returns to investors. Therefore, small-cap fund investors can ditch the institutional and large-cap investors to capitalize over small-sized companies. Small-cap funds can deliver better returns than large-cap or medium-cap funds in the bull markets as small companies can grow up to their full potential.

Features

Some notable features that define small-cap funds include the following points-

  • As per SEBI mandate, small-cap funds must invest more than 65% of the fund corpus in small stocks
  • They are capable of giving very high returns as they offer more room for growth
  • Although small-cap funds can deliver very high returns, sometimes taking over other equity-oriented funds under favorable conditions, they also come with high risks. These companies lack the financial resources to combat the tough market conditions and may succumb to bearish markets. Hence, they are highly volatile
  • Small-cap funds can deliver substantial returns in the long term because the small companies will take time to outshine in the market

 

Things to consider as an investor

Risk

Small-cap funds are more volatile than large-cap and mid-cap funds. At times when the markets are not performing well, small-cap funds suffer a lot as they are less established and opt to move out of business. On the other hand, it’s a great investment avenue for those who can tolerate more risk and are looking for more aggressive growth.

Returns

In the last couple of years, the market has seen the small category perform exceptionally well and has also attracted a lot of investor interest and money in this category. Small-cap funds are presumed to have significant yet hidden potential to be a “multi-bagger” (Indian financial jargon for equity stock which gives a return of more than 100%) one day.

Cost

Small-cap equity funds charge an annual fee to manage your money which is known as the expense ratio. SEBI has marked the upper limit for this at 2.25% of the average asset under management. A lower expense ratio translates into higher returns at the end of the day. So, while shortlisting a fund, look for one which has the lowest expense ratio.

Investment Horizon

The small-cap funds face substantial erosion of returns when the market starts going downwards. Hence, to allow the fund to generate returns according to your expectations, you need to stay invested for the long term. A long-term investment horizon is when you consider this option for a time horizon of 7-10 years.

Financial Goals

Small-cap equity funds can be ideal for investors who may have long-term goals like planning for your children’s education, saving for your retirement, taking an exotic vacation with your family, paying off your medium-term debt, and so on. Historically, these funds have delivered higher returns as compared to the broad benchmark when the markets are bullish. However, these can become highly risky bets. Thus, those who have a high-risk appetite may think of investing in these funds. These funds invest in companies which have great potential to generate good returns.

Tax on Gains

When you redeem units of small-cap equity funds, you earn capital gains. These capital gains are taxable in your hands. The rate of taxation depends on how long you stayed invested in these funds; such a period is called the holding period.

Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG is taxed at a rate of 15%. Conversely, capital gains made on holding more than one year are called long-term capital gains (LTCG). Due to the 2018 budget amendments, LTCG more than Rs 1 lakh will be taxed at 10% without the benefit of indexation.

Should You Invest in Small-Cap Funds?

Before making any investment decision, investors should plan their investment goals, the time duration they wish to stay invested before they reap the fruits of it and their risk profiles. Then, check out the investment avenues that are in alignment with your plans and mutual funds that suit your purpose. Here are a few things to consider before investing in small-cap funds:

Capital Appreciation

Invest in small-cap funds if you intend to have significant capital appreciation. Equity funds are meant for wealth creation and small-cap funds focus on growth opportunities that can create a valuable asset for the investors. Small-cap funds’ inclusion in the investment portfolio will not only diversify it but also balance it. Suppose your large-cap investments are not giving returns as per expectations, then small-cap funds may outdo them. When market movements impact small-cap funds’ returns, large-cap funds will stabilize the portfolio returns.

Long-Term Investment Horizon

Small-cap funds are suitable for investors with a long-term investment horizon of at least 5 or 7 years. Small-cap stocks are underlying assets with massive potential and aggressive expansion strategies for growth, but it will take some time to realize their value in the market. So, stay invested for a longer duration to enjoy the benefits through fantastic capital returns.

High-Risk Tolerance

Small-cap funds are suitable for investors with high-risk tolerance as they are highly susceptible to market volatility. These funds definitely give investors an opportunity to earn good returns as they confer more growth. However, they lack the financial strength and organizational stability of large-cap stocks. Therefore, small-cap funds are incredibly volatile and not suited for risk-averse investors.

Other than the above-mentioned points, always check the past performance history of the funds as well as the fund houses/AMCs (Asset Management Companies). Check the Expense Ratio, the performance of the competitor funds, and most importantly, the investment portfolio of the funds released by the fund houses. The detailed descriptions contain information about the stocks in which they are invested and in what proportions. This way you can know the companies and the sectors in which the fund’s corpus has been utilized. This will help you as an investor to make an assessment of the concentration risks (if sectors aren’t diversified) and credit risks (if small companies are not quality stocks). Nevertheless, fund managers take very calculated risks and thoroughly research before investing.

Conclusion

Small-cap funds, which means small-capitalization funds are equity mutual funds that invest majorly in stocks of small companies. Fund-managers invest in equities of small-sized companies that have shown positive signs of growth and a potential to be large-sized companies in the future. Early investors can get excellent returns on such stocks and therefore the fund managers of smallcap funds bet the fund money on it.

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