The funds wherein a major portion of the corpus is invested in equity or equity instruments of small-cap companies are known as small-cap funds. According to SEBI, at least 80% of the total assets of the small-cap scheme need to be invested in the small-cap companies.
Companies that are ranked below 250 in terms of their market capitalisation have been defined as small-cap companies. Their market capitalization is less than Rs. 500 crores.
Small-cap funds come with a very high level of risk. This is because even slight volatility can have a manifold impact on the price of shares of these small-cap companies.
On the other hand, these companies offer a huge potential for returns on their stocks. The reason being, a small-cap company has great scope for growth and when it does the share price will have an astounding increase.
Similarly, the small-cap company will not be cushioned enough to absorb the volatilities in the market due to which they are hard hit if worse conditions hit the market.
Investing in small-cap funds
One should opt for small-cap funds only if they have an appetite for high risk. Generally, one should resort to investing a small proportion of their portfolio to small-cap funds.
This is because small-cap funds are an excellent medium to earn huge returns but one needs to be patient. Small companies take time to change into large corporations which helps investors earn great returns even on small investments.
Factors to consider before investing in small-cap funds
- It is very important to analyse the risk-return ratio of small-cap funds before investing. This is because the Net Asset Value (NAV) is significantly sensitive. If the market conditions are not favourable, these funds suffer great losses. On the other hand, they have the potential to offer huge returns to those willing to take risk for aggressive growth.
- Choose a scheme with a lower expense ratio. Every fund house charges a fee to manage your funds. It is calculated as the percentage of total assets of the scheme. These expense charges are deducted from your returns, therefore it is wiser to choose a scheme with a lower expense ratio.
- Choose a longer term of investment. This is because they are highly sensitive and a slight change leaves a great impact on these funds. In order to give sufficient time to the funds to grow, it is important to have a long-term window. Eight to ten years is the recommended time window.
Taxes for small-cap mutual funds
- Small cap mutual funds are subject to Dividend Distribution Tax (DDT) and Capital Gains Tax.
- The fund house is supposed to deduct a Dividend Distribution Tax of 10% before they pay out the dividend. Whereas, Capital Gains Tax (CGT) is charged on the profit made by selling the investment. Rate of CGT depends on the holding period.
- When you invest in a small-cap mutual fund with a short holding period of less than one year, then the returns or the capital gains are taxed at 15% . These returns from short term holdings are known as Short Term Capital Gain.
- If you hold your investment for more than one year in small-cap mutual funds. They are termed as Long Term Capital Gain (LTCG). If the LTCG is below one lakh or is one lakh then it is not taxed. Anything above one lakh is taxed at 10% exclusive of indexation.
To sum up, an individual must consider investing in small-cap mutual funds only after considering the risk-return and expense ratio since they are highly volatile.