What is Small Cap Fund? Advantages of Small Cap Fund

An investment tool aims at a single goal: wealth creation. Mutual funds are the preferred choice for achieving this goal. Mutual funds are classified into many types: Debt funds, equity funds, small cap funds, mid-cap funds and so on.

In this article, let’s have a detailed look at small cap mutual funds.

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What is Small Cap Fund? Advantages of Small Cap Fund​

What is Small Cap Fund?

Small cap funds are a type of equity mutual fund. Investment is in stocks of companies with smaller market capitalization. Market capitalization means the market value of a company’s outstanding shares divided by the number of outstanding subscribers. Generally, the market capitalization of small cap firms is below Rs 500 Crores.

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Things to Know While Investing in Small Cap Funds

While investing in a small cap fund, there are a number of things to be considered.

1. Risk

Small cap funds are very risky. Even a slight fluctuation in the market, is likely to impact the share prices of small cap funds.

2. Returns

Though risky, small-cap firms have huge growth potential. Although it takes time for small firms to grow, they are more likely to grow within a few years. Long term investment in small cap funds (7 to 10 years) fetches desirable returns.

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3. Cost

Fund houses generally charge a sum for administering and managing stocks. It is ideal to choose a fund with lower expense ratio to get higher returns over a period of time.

4. Financial Goals

Small cap funds will give good returns if invested over a longer duration of time. Therefore, it is a suitable option if you have long term goals like saving up for retirement, children’s education and so on.

5. Investment horizon

Small cap funds must be invested for a longer time ranging from 7 to 10 years. This is because market dynamics affect the stock prices and investing for a longer time helps balance out these fluctuations.

Why Should You Invest in Small Cap Funds?

Small cap funds have a number of advantages that makes them an attractive investment.

1. Growth potential of small cap funds is very high. If the right stocks are picked, they are likely to give attractive returns.
2. Institutional investors tend to ignore small cap funds. This gives a great opportunity to smart investors. They can focus on these untapped segments and make profits.
3. They provide room for diversification.
4. Sometimes, small cap stocks outperform large cap stocks.

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Small Cap Fund Returns

Small cap funds have the potential to give high returns. They can yield high returns when the market trends are favorable. You must invest over a long period of time, so that sufficient time is given to the fund for generating returns.

Taxation

Small cap funds are eligible for two types of tax deductions. These are:

1. Dividend distribution tax (DDT): The Fund house must pay DDT at the rate of 10%, before paying dividends to the investors.
2. Capital gains tax: Capital Gains made from selling the shares of small cap firms is taxable. Tax rate depends on the holding period of the investment. If the investment is held for less than a year, then capital gains will fall under short term capital gains (STCG) and will be taxed at 15% with cess.

If the investment is held for more than a year, then capital gains are considered to be long term capital gains (LTCG). LTCG up to Rs 1 Lakh is tax free. Beyond this limit, it is taxed at 10% (without indexation).

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Risks of Investing in Small Cap Funds

1. Low liquidity: Small cap funds offer low liquidity. They are often faced by lack of buyers, when the stock market is bearish (prices falling). The difficulty to sell shares during urgent situations lowers the liquidity of the investment. 
2. Waiting period: Small cap funds are profitable if they are held for a long time. With time, they generate high returns. However, if you are looking for investments that will fetch returns in the near future, then small cap funds are not a great option.
3. Quality of management: As small cap funds involve small companies, it is difficult to understand the quality of management and develop trust with the firm. Lack of information is the main reason for this drawback.

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Disadvantages of Small Cap Funds

1. High risk and high volatility.
2. Not appropriate for all types of investors.  They are preferred by investors with high risk appetite and longer investment horizons.
3. Proper research is a mandatory clause for picking the right stocks.
4. In most of the cases, dividends are not available.
5. Time is very crucial. The buying and selling of these stocks must be carried out very carefully.

Top Five Small Cap Funds 2020:

SL. NO	FUND NAME	1 YEAR RETURNS (%)	3 YEAR RETURNS (%)	5 YEAR RETURNS (%)
1	Axis small cap fund	26.49	16.55	12.73
2	HDFC small cap fund	-2.74	12.23	10.37
3	L&T emerging business fund	0.67	10.68	11.40
4	Nippon India small cap fund	6.60	11.45	11.41
5	Franklin smaller companies fund	0.50	5.36	7.91

Conclusion:

Each investment option has risks and advantages. Before investing; all you must do is monitor your current situation and pick the investment scheme that is ideal.

 If you are capable of taking risks and trust the growth of a small cap company, then go forward and invest!

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