Small-cap stocks have delivered 31% annualized returns from 2019-24, outperforming many other investment categories. Consequently, small-cap fund folios have jumped from Rs 50 lakh to Rs 2.35 crore from 2019-24, as investors have begun to show an increasing interest for these ‘high-reward’ investments. However, with the promise of high rewards, there is also more risk and high volatility with small-cap funds. 

Now, let us see what small cap funds are, how they work, and why this type of mutual fund could be a good tool for your portfolio.  

What are Small-Cap Funds?

Small-cap funds are those mutual funds that invest primarily (minimum of 65% allocation) in small-cap companies, i.e. with market capitalization ranking of 251 or lower. As the growth of these companies is in its initial stages, they offer tremendous upside potential. However, they tend to be much more volatile than large-cap or mid-cap stocks.

Unlike large companies that have stable earnings and lower risk, small-cap companies are still establishing themselves. This presents an opportunity for high returns but also more significant market fluctuations. 

Key Features of Small-Cap Mutual Funds

  • Strong Growth Opportunities: Small-cap companies are often emerging companies which allows them more room to grow. If they succeed, their stock prices can appreciate quite a lot and can make investors big money.
  • Suitable for Long-Term Investors: Due to their high volatility, these funds are perfect for investors who can be invested for at least 5+ years to navigate market cycles and capitalize on long-term growth.
  • High Risk, High Reward: As they invest in firms that are still in the evolving stage, small-cap funds tend to be riskier compared to large-cap funds. They are more sensitive to market ups and downs and hence their performance is very volatile.
  • Focus on Small-Cap Stocks: These funds concentrate on small-cap stocks, providing access to high-growth companies that may eventually become market leaders.

How Do Small-Cap Funds Work?

Small-cap mutual funds pool money from various investors in a diverse portfolio of small-cap stocks. As the companies grow, their stock prices rise, benefiting investors. However, due to market volatility, investors may experience short-term fluctuations before realizing long-term growth.

Why Invest in Small Cap Funds?

  • High Growth Potential: Small-cap companies have more room for expansion than large, established businesses. As they scale up, they often generate high returns.
  • Potential for Superior Returns: Historically, small-cap funds have delivered higher long-term growth than large-cap funds, though they come with greater short-term risk.
  • Diversification: Including small-cap funds in a portfolio helps you to access companies in early stages of their growth and many of these companies may operate in niche markets or have innovative products. This complements your existing holdings in large-cap and mid-cap funds and offers diversification beyond the traditional sectors. 
  • Dynamic Market Exposure: Small-cap funds offer exposure to new-age industries, startups, and high-growth sectors, providing you with a stake in tomorrow’s market leaders. Small-cap companies are usually more innovative and agile than larger companies. They are often industry disrupters and creators of new products and technologies. 
  • Tax Efficiency: Long-term investments in small-cap funds (held for one year and above) are taxed at 12.5% for gains exceeding Rs 1.25 lakh, making them more tax-efficient than other short-term investments.

Who Should Invest in Small Cap Funds?

Small-cap funds are best suited for investors who:

  • Have a high-risk tolerance and can handle market fluctuations.
  • Have a long-term investment horizon of at least 5 years.
  • Are looking for high returns compared to large-cap or mid-cap funds.

These funds are not ideal for risk-averse investors or those seeking stable or short-term gains.

How to Invest in Small-Cap Funds?

Investing in small-cap funds is simple and convenient with PhonePe  that allows you to start investing from the comfort of your home.

  • Open your PhonePe app
  • Click on Mutual Funds
  • Scroll down and select Small Cap Funds
  • Select a Fund
  • Click on Invest Now

Conclusion

Small-cap funds are an excellent opportunity for investing in companies with high-growth potential. While the risk these funds carry is high, the potential for huge returns can be a compelling reason to invest if you have a high risk appetite. 

PhonePe offers an easy and secure way to invest in small-cap funds. Browse through, compare and add the best small-cap funds to your portfolio today.