Q. I am a 40-year-old businessman, and till now I have been investing in low-risk financial products such as fixed deposits and fixed-income plans. I wish to invest a part of my income in high-risk financial instruments such as equity mutual funds. I understand that small-cap index funds offer you the best of both worlds: low investment costs as well as high returns. Can you please elaborate on the same?
Viren Kasgaonkar, Pune, Maharashtra
Before understanding what a small-cap mutual fund is, it is important to understand that all mutual fund investments are subject to market risk and that the returns are never guaranteed.
We will first describe in detail what small-cap mutual funds are before moving on to small-cap index funds. Small-cap mutual funds are types of mutual funds that put most of their money into the stocks of small-cap companies. The Securities and Exchange Board of India’s (SEBI) regulations also mandate that small-cap mutual fund schemes should invest at least 65% of their total assets in small-cap companies.
SEBI defines small-cap companies as those companies whose market capitalization ranks below the top 250 companies listed on the stock exchange (in terms of market capitalization). They are typically companies with a market capitalization of less than ₹500 crores. The top 100 listed companies in terms of market capitalization are classified as "large-cap" companies. Companies starting from 101st to 250th in terms of market capitalization are classified as mid-cap companies.
Because of their small size, these companies have a significant opportunity to develop into large-capital businesses and provide profitable returns to their investors. Small-cap mutual funds have become a popular way to invest because of their potential to deliver high returns.
READ MORE: Investing in small cap funds: Are they good and bad both at the same time?
Why are small-cap funds typically volatile?
Under SEBI regulations, small-cap mutual fund schemes are permitted to invest in small-cap companies' equity or equity-related instruments. These investments carry a high degree of risk and are very volatile. The share prices of small-cap companies are impacted by even the smallest amount of market volatility. As the business grows, these stocks may provide investors with a high return. Given the small size of its operations, it is relatively easier for a small-cap company to give higher returns.
If the company has achieved the right product-market fit, it can increase its revenue and market cap multifold within a few years. A large-cap company, on the other hand, will find it extremely difficult to double or triple its revenue or market cap in a short span of time.
Now that we are clear with small-cap mutual funds, let's understand what index funds are before we describe what small-cap index funds are.
READ MORE: Why should you have at least one small cap fund in your mutual fund portfolio?
What is an index fund?
As its name suggests, an index mutual fund’s portfolio mimics stock market indices like the NSE Nifty, BSE Sensex, Bank Nifty etc. These are passively managed funds, which implies that the fund manager doesn't actively make a stock selection and the mutual fund’s portfolio's composition does not deviate from the index being tracked. These funds aim to provide returns that are identical to the index they track.
In general, index funds are regarded as strong foundational investments for retirement plans. According to the famous American investor Warren Buffett, index funds are a secure way to save for retirement.
What is small-cap index fund?
Small cap index funds is an index fund tracking a small-cap index such as NIFTY Smallcap 100 Index. Essentially, the mutual fund will be investing in those companies which constitute the index it is tracking.
Small-cap index funds like any other small-cap fund are required to invest at least 65% of their corpus in small-cap companies and consequently, these funds have the potential to deliver high returns.
However, since they are tracking an index therefore they are also passive funds, since the fund manager does not actively take any investment decision, the expense ratio of these funds is lower than that of active small-cap funds.
Small-cap funds are ideal for investors who want to benefit from the growth potential of the small-cap companies but at the same time are wary of active mutual funds and the risk associated with investing in small-cap mutual funds. In a way, they deliver the best of both worlds.
READ MORE: Why investing in small-cap funds is not a bad idea?
Advantages of investing in small-cap index funds
Higher growth potential: Small-cap funds have a high chance of growth because they invest in small companies with more expansion opportunities. Compared to larger enterprises, these businesses are better suited to scale their operations.
Diversification benefits: Having small-cap index funds in your portfolio can help you with the diversification of assets in your portfolio, especially by adding assets with a smaller market capitalization.
Merger and acquisition potential: Small-cap companies have a higher likelihood of mergers and acquisitions. To grow inorganically, they can be bought out or merged with their more established competitors. Because of this, the share prices of smaller companies might go up, which would eventually make small-cap funds more valuable.
Low liquidity: Small-cap companies don't have a lot of buyers and sellers on the stock market. However, some investors think this is a disadvantage. Investors who believe that the company will benefit from this. Once the company's earnings and revenue are made public, there may be a lot of investors who want to buy its shares, and publicly traded shares are in great demand and have a limited supply, which causes prices to climb quickly.
Challenges associated with investing in small cap
Index Funds: Smaller companies are more susceptible to market risks. Most of the time, they cannot endure a financial crisis or an economic slump. Further, many times many small-cap businesses fail while attempting to compete with their larger rivals. Small-cap funds that invest in these may even not be able to recover their original investment. People who have a low-risk appetite should ideally stay away from small-cap index funds.
Small-cap index funds track a small-cap index and allow investors to potentially get a high return with low investment cost. However, these companies have smaller balance sheets and are more affected by the economic cycle, ideally, long-term investors with a high-risk appetite should invest in small-cap index funds.
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Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.