What is A Small Cap Fund? A Simple Guide For Investors

Investors looking for high-growth opportunities in the equity market often come across small-cap mutual funds. These funds invest in emerging companies that have the potential to grow faster than established giants. But with higher return potential also comes higher risk.

In this blog, we’ll explain what is small cap fund, how small-cap mutual funds work in India, their features, advantages and disadvantages, taxation, and how you can invest in them.

What Are Small-Cap Mutual Funds?

Small-cap mutual funds are equity mutual funds that invest primarily in small-cap companies, businesses that are relatively smaller in size but have high growth potential. These companies are usually in the early or expansion stage of their business lifecycle.

So, what is small cap fund in mutual funds?

It is a mutual fund scheme that invests a majority of its portfolio in small-cap stocks with the objective of long-term capital appreciation.

What Is Small Cap in Mutual Funds? SEBI Definition

The Securities and Exchange Board of India (SEBI) classifies companies based on market capitalisation. Market cap simply means the total market value of a company’s shares.

To make this easier for beginners, here’s a clear comparison:

As per SEBI rules, small-cap mutual funds must invest at least 65% of their assets in small-cap companies. This ensures clarity and uniformity across all mutual fund houses in India.

How Do Small-Cap Mutual Funds Work?

Understanding how small-cap mutual funds operate helps investors set realistic expectations regarding returns and risk.

1. Pooling of Capital:

Small-cap funds allow individual investors to gain exposure to a diversified portfolio of “future market leaders” with relatively small investments, often starting at ₹100 - ₹500 through SIPs. By pooling capital from multiple investors, the fund can invest across 40–80 stocks, achieving diversification that would be challenging and costly for an individual investor.

2. Specialised Stock Selection:

Small-cap companies are often under-researched by large institutions, creating opportunities for skilled fund managers to identify promising companies early.

Key considerations for stock selection include:

• Low debt-to-equity ratio, ensuring financial stability
• High return on equity (ROE), indicating efficient use of capital
• Strong fundamentals to withstand the challenges of growth

This careful selection process allows the fund to invest in companies with strong potential while mitigating risks associated with weaker small-cap firms.

3. Active Portfolio Management:

Small-cap stocks can experience rapid changes in performance, requiring active monitoring. Fund managers frequently review and adjust the portfolio, exiting positions if a company’s fundamentals deteriorate. This higher portfolio turnover is necessary to protect investors from significant losses in underperforming stocks.

4. Daily NAV and Volatility:

The Net Asset Value (NAV) of small-cap mutual funds is calculated at the end of each trading day.

Due to the relatively low trading volumes of small-cap stocks, even modest buy or sell activity can lead to significant price fluctuations. This explains why small-cap funds are generally more volatile than large-cap funds.

5. Liquidity Management:

Small-cap stocks may be harder to sell during market downturns, creating liquidity risk. To address this, SEBI requires fund managers to conduct liquidity stress tests and maintain adequate cash or large-cap holdings. This ensures the fund can meet redemption requests without being forced to sell small-cap stocks at unfavourable prices.

6. Systematic Investment Plans (SIPs) and Rupee Cost Averaging:

SIPs are particularly effective for small-cap funds. By investing a fixed amount regularly, investors buy more units when the NAV is low and fewer when the NAV is high, a principle known as rupee cost averaging. Over the long term, this approach helps manage volatility and can lead to superior wealth creation compared to a single lump-sum investment.

Key Features of Small-Cap Mutual Funds

Some defining features of small-cap mutual funds include:

1. High Growth Potential: Small-cap companies are often in their early business stages. Because they have a smaller base, a new contract or a successful product can cause their revenue (and stock price) to grow much faster than a large, established giant.

2. High Volatility and "Drawdowns": Small-cap funds have the highest volatility among equity funds. In a market correction, these funds can see "drawdowns" (temporary losses) of 30% or more.

3. Long-Term Horizon (The 7–10 Year Rule): While 5 years is the minimum, most experts now recommend 7–10 years for small caps. This is because small companies need time to navigate business cycles and for the "power of compounding" to truly take effect.

4. Professional Stock Selection: Since these companies are less researched by big institutions, they are often "undervalued." A skilled fund manager can find "hidden gems" before the rest of the market, potentially leading to Alpha (returns higher than the benchmark index).

5. Sector Diversification: Small-cap funds often provide exposure to niche industries, like specialised chemicals, green energy tech, or consumer startups, that are not yet represented in the Nifty 50 or Large-Cap funds.

6. Liquidity Management: This is a critical feature today. Because small-cap stocks can be hard to sell during a panic, funds are now required to:

• Hold Cash/Large Caps: Use the remaining 35% of the portfolio to maintain a "liquidity buffer."
• Stress Testing: Publish regular reports showing how many days it would take to liquidate 25% or 50% of the portfolio.

How to Know If a Small-Cap Mutual Fund Is Right for You?

Here’s a structured way to evaluate whether a small-cap fund fits your portfolio:

1. Assess Your Risk Appetite:

Small-cap stocks are inherently more volatile than large-cap or mid-cap stocks. Investors must be comfortable with:

• Short-term fluctuations in NAV
• Possible periods of negative returns
• Sudden market corrections

If you are risk-averse or need stability in the short term, small-cap funds may not be appropriate.

2. Evaluate Your Investment Horizon:

Small-cap funds require a long-term perspective to realise their growth potential. Ideally, your investment horizon should be:

• 7–10 years or more
• Flexible enough to ride out market cycles

The longer you stay invested, the higher the probability of benefiting from compounding and the fund manager’s stock selection.

3. Consider Your Existing Portfolio:

Small-cap funds are aggressive growth instruments. Before investing, check if your portfolio is balanced:

• If most of your investments are already in large-cap or debt funds, adding a small-cap fund can improve diversification and potential returns.
• If your portfolio is heavily concentrated in equities already, adding small-cap exposure could increase overall risk.

4. Review the Fund’s Track Record (But Avoid Chasing Past Returns):

While past performance is not a guarantee, consistency matters:

• Rolling Returns: Look at performance across multiple 1-, 3-, 5-, and 7-year periods rather than just last year’s returns
• Risk Metrics (Standard Deviation / Beta): Understand how much the fund fluctuates relative to the market
• Fund Manager Experience: Experienced managers are critical for identifying winning small-cap stocks

Pro Tip: Avoid selecting funds solely based on last year’s “multibagger” performance. Consistency over multiple market cycles is more important than short-term gains.

5. Check the Fund Size (AUM):

While a larger Assets Under Management (AUM) indicates popularity, very large small-cap funds (₹30,000 Cr+) can face challenges:

• Limited opportunities to deploy large amounts in small-cap stocks
• Difficulty in maintaining high returns while managing liquidity

A moderately sized fund often allows the manager to invest efficiently without compromising on growth potential.

6. Confirm Your Comfort With Volatility and Liquidity:

Even after assessing your risk appetite and horizon, ask yourself:

• Can you remain invested during sharp market declines?
• Are you prepared for your fund’s NAV to swing significantly in the short term?
• Do you understand liquidity risk if you need to redeem during a market downturn?

If the answer is yes, small-cap funds can be a strategic growth component in your portfolio.

How to Invest in Small-Cap Mutual Funds in India?

Investing in small-cap mutual funds is simple and accessible. Here’s a step-by-step guide to get started:

1. Choose Your Investment Platform:

You can invest in small-cap funds through:

• AMC (Asset Management Company) Websites: Directly invest with companies.
• Mutual Fund Apps or Aggregators: These platforms allow easy comparison and investment in multiple funds.
• Registered Distributors or Financial Advisors: They can provide guidance based on your goals, risk tolerance, and portfolio.

2. Decide Between SIP and Lump Sum:

Small-cap funds are more volatile, so the investment method matters:

a) Systematic Investment Plan (SIP):

Invest a fixed amount regularly (e.g., ₹500–₹5,000/month). SIPs use rupee cost averaging, buying more units when the NAV is low and fewer when the NAV is high. This helps manage volatility and reduces the risk of market timing.

b) Lump Sum Investment:

Investing a one-time amount can work if markets are favourable, but it carries a higher risk due to market swings.

• Pro Tip: SIPs of at least 7 years are generally recommended for small-cap funds to benefit from compounding and ride out market volatility.

3. Complete KYC (Know Your Customer):

Before investing in any mutual fund, you must complete KYC:

• Submit PAN, Aadhar, and bank details
• Complete in-person or e-KYC verification

Most online platforms allow instant KYC verification, making the process quick and paperless.

4. Select the Right Small-Cap Fund:

Factors to consider when selecting a fund:

• Fund’s Rolling Returns to check consistency over 3–5 years
• Risk Metrics (Standard Deviation / Beta) to understand volatility
• Fund Manager’s Track Record in selecting small-cap stocks
• Expense Ratio to ensure costs don’t eat into returns
• Fund Size (AUM): Moderately sized funds can often deploy capital more efficiently

5. Monitor and Stay Invested:

Once invested:

• Monitor NAV and portfolio composition periodically
• Avoid making hasty decisions during market corrections
• Stay invested for the long-term (7–10 years) to maximise potential growth

Small-cap mutual funds require patience, but with disciplined investing, they can significantly enhance your portfolio’s growth potential.

Advantages & Disadvantages of Small-Cap Mutual Funds

Investing in small-cap mutual funds can be highly rewarding, but it comes with unique risks. Understanding both sides helps investors make informed decisions.

Advantages

• High Growth Potential: Small-cap companies are in the early or expansion phase of their business. If these companies succeed, their stock prices can grow significantly, giving investors higher returns than large-cap or mid-cap funds over the long term.
• Opportunity to Invest Early in Future Leaders: Small-cap funds provide access to emerging companies before they become widely recognised. This early exposure increases the chances of benefiting from their growth story.
• Portfolio Diversification: Adding small-cap funds can balance a portfolio that is heavily weighted in large-cap or debt instruments, spreading risk and enhancing potential returns.
• Potential for “Multibagger” Returns: While not guaranteed, some small-cap stocks can become multi-fold in value over time, offering substantial wealth creation opportunities for long-term investors.

Disadvantages

• High Volatility: Small-cap stocks are sensitive to market movements. The NAV of small-cap funds can swing sharply, making short-term returns unpredictable.
• Liquidity Risk: In market downturns, selling small-cap stocks can be challenging due to fewer buyers, which may lead to sharper falls in the fund’s NAV.
• Higher Dependence on Fund Manager Expertise: Selecting successful small-cap companies requires skill. Poor stock selection can result in underperformance or losses, making the fund manager’s track record critical.
• Longer Investment Horizon Required: Small-cap funds typically require a 7–10 year horizon to realise their growth potential. Investors with short-term goals may not benefit fully and could face losses.
• Some Companies May Fail: While small-cap funds aim for high-growth firms, many small companies do not scale or may fail, which adds risk to the investment.

Taxation of Small-Cap Mutual Funds

For tax purposes, small-cap mutual funds are treated as equity mutual funds.

• Short-Term Capital Gains (STCG): Gains on units sold within 12 months are taxed at 20% (plus surcharge and cess).
• Long-Term Capital Gains (LTCG): Gains on units sold after 12 months are taxed at 12.5% on gains exceeding ₹1.25 lakh per financial year (without indexation).

Dividends are taxed as per the investor’s income tax slab.

List of Small-Cap Mutual Funds

Several small-cap mutual fund schemes are available in India.

Risks of Investing in Small-Cap Mutual Funds

While small-cap mutual funds offer high growth potential, they also carry unique risks that investors must understand before investing.

1. Market Volatility: Small-cap stocks are more sensitive to market fluctuations than large-cap stocks. This means:

• NAVs can rise or fall sharply in short periods
• Short-term returns are unpredictable
• Investors must be prepared for significant fluctuations during market corrections.

2. Liquidity Risk: Many small-cap stocks have lower trading volumes, making them harder to sell quickly during a market downturn. Consequences include:

• Fund managers may struggle to meet redemption requests promptly
• NAV may decline more sharply compared to funds with large-cap holdings

SEBI now requires liquidity stress tests to ensure funds maintain sufficient cash or liquid assets to handle redemptions.

3. Higher Dependence on Fund Manager Expertise: The success of a small-cap fund depends heavily on the fund manager’s ability to pick the right stocks:

• Poor stock selection can significantly impact returns
• Identifying “future market leaders” requires experience and deep research
• Active management is critical because small-cap companies can fail or underperform

4. Company-Specific Risks: Small-cap companies are typically in early growth stages, so:

• Many may fail to scale or remain small.
• Financial or operational challenges can lead to sharp declines in stock value.
• Investors are exposed to higher company-specific risk than in large-cap funds.

5. Economic and Market Sensitivity: Small-cap companies are often more vulnerable to:

• Economic downturns
• Changes in interest rates or inflation
• Sector-specific challenges

During such events, small-cap funds may underperform large-cap or mid-cap funds.

6. Long-Term Commitment Required: Because of volatility and growth cycles, small-cap funds typically require a long-term investment horizon (7–10 years). Early withdrawals during market downturns can lead to losses, reducing the potential benefits of compounding.

Conclusion

Understanding what is small cap fund is goes beyond just return potential. Small-cap mutual funds offer an opportunity to participate in India’s future growth story, but only for investors who can handle volatility and stay invested for the long term.

With the right expectations, disciplined SIP investing, and a focus on fundamentals rather than hype, small-cap mutual funds can become a powerful component of long-term wealth creation.