Small-cap mutual funds: An introduction to investing in small companies

In investing, various categories of companies are based on their market capitalization. One such category is small-cap companies, representing a unique and often overlooked investment opportunity.

Small-cap companies are companies with a relatively smaller market capitalization. In India, companies with a market capitalization below a certain threshold, such as ₹5,000 crore, are considered small-cap companies. These companies are usually in their early stages of growth or operate in niche industries, presenting higher growth potential.

What you need to know about Small-Cap Mutual Funds

Benefits of investing in small-cap companies

  • Growth potential: Small-cap companies have the potential to deliver substantial growth over the long term. These companies often operate in sectors with significant growth opportunities, allowing investors to capitalize on emerging trends and disruptive technologies.
  • Undiscovered gems: Small-cap companies are often under-researched and may not receive as much attention from institutional investors or analysts as larger companies. This creates an opportunity for strategic investors to identify undervalued companies with untapped potential.
  • Early entry advantage: Small-cap mutual fund investments allow investors to enter at an early stage of their growth trajectory. As these companies expand and mature, their market capitalization and share prices may increase, potentially leading to attractive returns for early investors.
  • Portfolio diversification: Including small-cap mutual funds in your investment portfolio can provide diversification benefits. Small-cap companies often exhibit different performance patterns than large-cap or mid-cap companies, which can help reduce overall portfolio risk.

Risks and Considerations of Investing in small-cap Companies

  • Higher volatility: Small-cap companies tend to be more volatile than larger, well-established ones. They may be susceptible to market fluctuations, economic downturns, or company-specific risks. Investors need to be prepared for short-term price fluctuations and exercise patience during periods of volatility.
  • Liquidity concerns: Small-cap stocks may have lower trading volumes, resulting in more inferior liquidity. During periods of market stress, it may be challenging to sell small-cap holdings quickly at desired prices. Long-term investors who can withstand short-term liquidity constraints may find small-cap investments more suitable.
  • Higher risk of business failure: Small-cap companies are often in the early stages of their business lifecycle and face higher loss risks than established companies. Due diligence and thorough research are essential when investing in small-cap mutual funds to identify companies with strong fundamentals, competent management teams, and sustainable growth prospects.

Suitability and comparison to large-cap and mid-cap funds

Investing in small-cap mutual funds suits investors with a higher risk appetite and a longer investment horizon. Investors who believe in the growth potential of emerging companies and are willing to tolerate short-term volatility can benefit from exposure to small-cap stocks.

Compared to large-cap and mid-cap funds, small-cap funds offer the potential for higher returns but also come with increased risks. Large-cap stocks are typically more stable and may provide steady returns, while mid-cap stocks offer a balance between growth potential and risk. Small-cap funds occupy the higher risk-reward spectrum, appealing to investors seeking higher growth opportunities.

One way to invest in such small-cap funds is through a SIP plan to help you balance your risk appetite and finances. Use a mutual fund SIP calculator to create investment plans that complement your savings and financial goals.

Wrapping up

Investing in small-cap mutual funds can be rewarding for investors willing to embrace higher risk in pursuit of potentially higher returns. By understanding the unique characteristics, growth potential, and risks associated with small-cap companies, investors can make informed decisions and benefit from the growth stories of emerging businesses. However, assessing your risk tolerance, diversifying your investments, and seeking professional advice to ensure that small-cap mutual funds align with your financial goals and overall investment strategy is important.