Mutual Fund Investment: How to select and invest in small cap funds

Published: January 27, 2020 11:44:48 AM

Planning to invest in small cap funds? Let us look at some of the key aspects investors should look for before selecting and investing in these funds.

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After the Securities and Exchange Board of India’s (SEBI) scheme categorisation of mutual funds as per market capitalisation of underlying stocks, the definition of mutual funds has changed and it has brought more clarity and transparency. As per the new arrangement, small cap funds are those funds which invest at least 65% of their corpus in stocks of companies which have small capitalisation or market share and which are ranked from 251 – 500 in the market capital wise categorisation of companies.

For ease of understanding we can highlight certain features which define and separate small-cap companies from others:

These are companies

a) with lowest market capitalisation in the universe of listed companies

b) which are in their initial phase of business and are looking for expansion and growth

c) where the scope for share price appreciation during market highs is quite high and so is it for price slide during market lows

d) which are expected to gain more than the broader market in a rising economy

Benefits of investing in Small Cap Funds

Small cap funds give an extra edge that a portfolio needs. If large cap funds bring stability to the portfolio, small cap funds, with the high potential, strong growth expectation, aggressive expansion objective and market beating performance, lift the overall returns on investments.

These are managed by professional managers who, through in depth research, identify ‘winners of tomorrow’ and help generate ‘alpha’ for the investors’ portfolio.

Although volatile in nature, the scope of return over a longer period of time is quite high and works in the favour of the small cap fund investors.

Let us now look at some of the key aspects investors should look for before selecting and investing in Small Cap funds:

1. Risk Involved

Small cap funds mostly invest in new companies or companies servicing specific areas, businesses or are companies with greater opportunities and high potential. These companies might have the added advantage of a new product offering or service and come with a USP or might even service a niche demand.

As is quite evident, small cap funds investing in such companies are more volatile due to risks associated with smaller companies which are either starting out or have only a few years of operational experience. Such companies come with additional risk of limited fundraising capabilities, smaller scale of operations and market to operate in, there is the missing benefit of economies of scale and limited scope for attracting talent etc.

Still, these are part of the stock markets and hence will be measured vis a vis their performance metrics and against the competition as well.

Investors need to assess these funds against their own risk profile and should arrive at a decision with a defined amount which they can invest for a considerable period of time.

2. Potential scope of return

In addition to the current profitability and the level at which small cap companies are operating, the future potential is what the investors should look at.

Small cap funds can become the star performers in no time, due to multiple factors working for them. The same factors which might turn negative for a short while in a slowing economy, lend them the heft to become outperformers when the economy is in an upswing.

3. Investment time-frame

Small cap funds should be looked at from a long-term time-frame. This is because these companies are not established and for proving their worth, they would need to address some or all of these – invest in expansion capabilities, plant and machinery, developing technical or technological capabilities, cater to fundraising needs etc. This obviously takes time and will start yielding results only after a certain period of time. Remember what they say in markets ‘today’s large cap companies or blue chips started out as small caps.’ Thus, before investing in small caps, a clear strategy should be devised.

4. Expense Structure and Taxes

Expense structure which is referred to as ‘Expense Ratio’ or ‘Total Expense Ratio’ needs to be kept in mind because higher expenses reduce the overall returns considerably. Although it might seem to be small, even a 1 percent difference in the expense ratio of funds reduces the returns significantly over 10 – 15 – 20 years.

The tax structure for small cap funds is similar to other equity funds. Redemption of small cap units will result in capital gains (or losses). The tax rate depends on the holding period of funds.

If the holding period is less than one year, the gains are taxed as Short Term Capital Gains (STCG) at the rate of 15 per cent.

In case of holding period of more than one year, Long Term Capital Gains (or losses) are generated and are taxed at the rate of 10 per cent over and above the exemption limit of Rs 10 lakh.

5. Alignment with specific Goals

Some investors try to capitalise through market gains and want to benefit from specific events or from market movements. However, small caps can prove to be tricky if the objective is quick returns within a small time-frame.

Investors should align their small cap investments with specific long-term goals. This is also beneficial because a longer time-frame gives the investments time to compound and provide better returns.

Conclusion

For making the best of the opportunity that lies in these funds, investors should choose the SIP route. They can add more through lump sum investment whenever they have an amount which they do not require for the foreseeable future.

Investors should also note that along with caution, patience to play out the volatility is what would eventually pay with small cap funds.

(By Harsh Jain, Co-founder and COO, Groww)

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