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As explained in our previous article about large-cap equity funds, understanding market capitalization (market cap) is essential for any investor today. Stocks of small-cap companies, having a market cap of less than ₹500 crore, are the black sheep of the stocks family. They are riskier compared to their counterparts but that is not the complete picture.

Here are some pros and cons of investing in small cap stocks.

Pros and cons of investing in small-cap stocks
Pros Cons
Exponential growth potential Risk and volatility
Usually untapped by institutional investors Timing of the buy and sale is critical
Lack of exposure offers good buying opportunities

What are small-cap equity funds?

Mutual fund houses offering small-cap equity funds realize the opportunities available by investing in small-cap stocks and are also aware of the risks involved. Most small-cap funds invest around 65%-90% in small-cap stocks. Usually, these stocks are identified by looking at the BSE or NSE small-cap indices. The remaining assets are spread between mid-cap and large-cap stocks to provide some stability to the investments. Furthermore, to help minimize risks, many schemes diversify their small-cap stock investments across different companies from varying sectors. The professional management team of the fund house has the required expertise and manpower to select the right stocks with optimum diversification.

Who should invest in small-cap equity funds?

When Australia plays Canada in a cricket match, do you find yourself rooting for Canada to the extent that you can put you money on it? Yes? Then, small-cap equity funds are just what the doctor ordered for you. It is important to keep in mind that small-cap stocks, apart from their range of benefits, carry some elements of risk. This is why small-cap equity funds are ideal only for seasoned investors. If you are new to mutual fund investments, then these funds may not be the best for you. Small-cap equity funds are best for investors who understand mutual funds and the risks that are associated with small-cap stocks.

You should analyse your risk appetite and determine your investment objectives before investing in these funds. Once that is done, you can then allocate a specific portion of your portfolio to small-cap equity funds.

Of course, small-cap equity funds have the potential to earn higher returns when compared to other diversified equity fund types. Here’s how the category has performed over different time periods.

Returns earned by small-cap equity funds
1-year 3-year 5-year 10-year
24.40% 21.20% 26.96% 14.24%

As on 29 September 2017

How to choose a small-cap equity fund?

Since these funds invest primarily in small-cap stocks, it is important to choose the fund wisely. Here are some pointers to help you separate the men from the boys:

  • The 5-year return mantra – To begin with, look at the past 5-year returns of these funds. Small-cap funds are volatile and are easily affected by market corrections. A comparative analysis of the past 5-years performance against the category benchmark will give you a better idea of the fund’s performance.
  • It’s all about the research – Success in small-cap stocks depends on the amount of time spent by the fund house in researching and finding unicorns in the small-cap segment. A fund house backed by a research team with a proven track record usually finds success in this segment.
  • Experience begets success – A fund manager with extensive experience in managing small-cap funds and an associated with a specific fund for a good number of years can ensure that the fund is in good hands and your investment will generate good returns.

Here are some good small-cap equity fund options

Fund name 1-year returns (%) 3-year returns (%) 5-year returns (%)
DSP BlackRock Micro Cap 16.47 23.45 28.99
Reliance Small Cap 31.34 21.01 30.48
SBI Small & Midcap Fund 33.02 27.20 32.63

As on 29 September 2017

Returns from small-cap equity funds are highly dependent on the choice of small-cap stocks invested in by the fund house. Research well before you choose to invest in any small-cap equity fund.

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