Your Questions Answered: I want to invest in small-cap mutual funds. Please elaborate on pros and cons

Q. I am a lecturer working at a government college in Bhagalpur, Bihar. My wife is a beautician running her own beauty parlour. We have been investing in large-cap mutual funds for the past 6 years. We now intend to diversify and invest in other categories of mutual funds. Our acquaintances have suggested that we should invest in small-cap mutual funds too. However, our understanding of small-cap mutual funds is limited. Please elaborate on the pros and cons of investing in small-cap mutual funds and how they differ from large-cap mutual funds.

Ravindra Srivastava, Bhagalpur, Bihar

Introduction

Small-cap mutual funds are equity funds that primarily invest in small-sized companies. These companies are beyond the top 250 companies listed on the stock exchanges in terms of market capitalisation. Due to their size, they have the potential for substantial growth, but they also face higher volatility and risk compared to large and mid-cap companies.

What are the different categories of stocks?

Before exploring small-cap mutual funds, it's essential to understand the basics of small-cap, mid-cap, and large-cap stocks. The Securities and Exchange Board of India (SEBI) classifies stocks into three categories based on market capitalisation:

Large-cap: These are the top 100 companies in terms of market capitalisation.

Mid-cap: These are the companies ranked from 101 to 250 in terms of market capitalisation.

Small-cap: These are the companies ranked 251 and beyond in terms of market capitalisation.

This classification helps in ensuring uniformity in the investment universe for equity mutual fund schemes.

What are small-cap mutual funds?

As per applicable SEBI regulations, small-cap mutual funds are equity mutual funds that invest at least 65% of their total assets in small-cap companies. These companies are ranked 251st and beyond in terms of market capitalisation. Small-cap mutual funds aim to capture the growth potential of smaller companies, which can offer higher returns but also come with higher risks and volatility compared to large and mid-cap funds.

Key differences between large-cap and small-cap mutual funds

Market capitalisation

• Large-cap: As per SEBI regulations large-cap mutual funds need to invest at least 80% of their corpus in large-cap stocks.
• Small-cap: In accordance with SEBI regulations small-cap mutual funds need to Invest at least 65% of their corpus in small-cap stocks.

Risk and volatility

• Large-cap: In comparison to mid-cap and small-cap mutual funds, large-cap mutual funds are relatively considered safer and less volatile due to the stability and established nature of the companies.
• Small-cap: In comparison to large-cap mutual funds, small-caps are known to have relatively higher risk and are more volatile. This is because small-caps are more susceptible to market fluctuations and economic downturns.

Growth potential

• Large-cap: In comparison to small-cap mutual funds, large-cap mutual funds offer steady and reliable growth, making them suitable for conservative investors.
• Small-cap: In comparison to large-cap mutual funds, small-cap mutual funds have the potential for high growth, making them attractive to aggressive investors looking for significant returns.

Liquidity

• Large-cap: Large-cap mutual funds invest in highly liquid large-cap stocks. As these stocks are frequently traded, they have good liquidity and high trading volumes.
• Small-cap: Small-cap mutual funds invest in relatively less liquid stocks, with lower trading volumes, which can make buying and selling shares more challenging.

Investment horizon:

• Large-cap: Large-cap mutual funds are suitable for investors with a medium to long-term investment horizon.
• Small-cap: Small-cap mutual funds are best suited for investors with a long-term investment horizon, typically seven years or more.

Pros of investing in small-cap mutual funds

Investing in small-cap mutual funds can be a rewarding strategy for those looking to diversify their portfolio and tap into the growth potential of smaller companies. While these investments come with higher risks, they also offer unique advantages that can lead to substantial long-term gains. Let's explore the key benefits of investing in small-cap mutual funds.

High growth potential: Small-cap companies are typically in the early stages of their growth cycle. They have significant room for expansion and innovation, which can lead to rapid increases in their stock prices. Investors who identify and invest in promising small-cap companies early can potentially reap high returns as these companies grow and succeed.

Diversification: Small-cap mutual funds provide exposure to a wide range of companies across various sectors. This diversification helps spread risk and can enhance the overall stability of your investment portfolio. By including small-cap funds, you can balance the performance of larger, more established companies with the dynamic growth potential of smaller firms.

Long-term gains: Investing in small-cap mutual funds is ideal for those with a long-term investment horizon. While small-cap stocks can be volatile in the short term, they tend to outperform large-cap stocks over extended periods. By holding onto these investments through market fluctuations, investors can achieve substantial gains over time.

Capitalising on market inefficiencies: Small-cap stocks are often less researched and followed by analysts compared to large-cap stocks. This lack of coverage can create opportunities for investors to find undervalued stocks that have not yet been recognised by the broader market. This gives room for small-cap investors to capitalise on these opportunities.

Economic growth: Investing in small-cap mutual funds also supports the growth of emerging companies that contribute to economic development. These companies often drive innovation, create jobs, and stimulate economic activity. By investing in small-cap funds, you are not only seeking financial returns but also contributing to the broader economy.

Potential for higher returns: Historically, small-cap stocks have delivered higher returns compared to large-cap stocks. While they come with higher risks, the potential for significant returns makes them an attractive option for investors willing to take on more risk for the possibility of greater rewards.

Cons of Investing in small-cap mutual funds

While small-cap mutual funds can offer significant growth potential and diversification benefits, they also come with certain risks and drawbacks. It's important for investors to be aware of these cons before deciding to invest in small-cap funds. Let's explore the key disadvantages of investing in small-cap mutual funds.

High volatility: Small-cap stocks are known for their high volatility. These companies are often more susceptible to market fluctuations and economic downturns. As a result, the value of small-cap mutual funds can experience significant swings, which can be unsettling for investors, especially those with a lower risk tolerance.

Economic sensitivity: Small-cap companies are often more sensitive to economic changes and market conditions. They may lack the financial resources and stability to withstand economic downturns, making them more vulnerable to adverse economic events. This sensitivity can lead to higher volatility and risk for small-cap mutual funds.

Factors to consider before investing in small-cap mutual funds

Investment horizon: Small-cap funds are suitable for investors with a long-term investment horizon, typically seven years or more.

Risk tolerance: These funds are ideal for aggressive investors who can tolerate high levels of risk.

Fund performance: Always review the historical performance of the fund and compare it with its benchmark.

Fund manager's expertise: The experience and track record of the fund manager play a crucial role in the fund's performance.

Taxation of small-cap mutual funds

The 2024 budget introduced significant changes to the taxation of capital gains from mutual funds in India. Let's delve into the details of how these changes impact small-cap mutual funds.

Capital gains taxation

The 2024 budget has overhauled the capital gains tax structure for mutual funds, including small-cap funds. Here are the key changes:

• Short-term capital gains (STCG): For equity-oriented mutual funds, including small-cap funds, short-term capital gains are now taxed at a rate of 20% if the holding period is less than 12 months. This is an increase from the previous rate of 15%.
• Long-term capital gains (LTCG): Long-term capital gains on equity-oriented mutual funds are now taxed at a flat rate of 12.5% if the holding period exceeds 12 months.

How do these tax changes affect investors?

The changes introduced in the 2024 budget have several implications for investors in small-cap mutual funds:

• Higher tax liability: The increase in the STCG tax rate and the removal of the indexation benefit for LTCG can lead to a higher tax liability for investors. This makes it essential to consider the tax implications when planning your investment strategy.
• Focus on long-term investments: Given the higher tax rates on short-term gains, investors may benefit from adopting a long-term investment approach. Holding investments for more than 12 months can help reduce the tax burden and maximise returns.

Conclusion

Small-cap mutual funds can be a valuable addition to your investment portfolio if you are looking for high growth potential and are willing to accept higher risks. By carefully selecting the right funds and maintaining a long-term perspective, you can potentially achieve significant returns.

Investing in small-cap mutual funds requires thorough research and a clear understanding of your financial goals and risk tolerance. Always consult with a financial advisor to make informed investment decisions.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

Kuvera is a free direct mutual fund investing platform. Unless otherwise stated data sourced from BSE, NSE and kuvera.