Small Cap Mutual Funds - Know Meaning, Advantages & Disadvantages

Let’s find out more about the benefits of investing in small cap mutual funds. We will also look at how to invest in these funds, points to consider before starting, and much more.

What is a Small Cap Mutual Fund?

Small cap mutual funds invest your money in a portfolio that consists mostly of stocks and equity-linked instruments of companies with small market capitalisation — usually ranking outside the top 250 companies in terms of market cap.

What is a Small Cap Company?
The definition of a small cap company varies by country. In India, small cap companies are usually those with a market cap of less than INR 5,000 crores (approx. USD 598 million) In the US, this mainly refers to companies with a market cap between USD 300 million and USD 2 billion.

This category includes organisations like start-ups or small-revenue corporations in their early stages of development. Small-cap mutual funds make investments in companies with high potential for future growth, albeit with high risk as well. These funds have the potential to generate big profits if you can bear relatively higher risk.

Note: During the bullish phases of the market, small cap funds can often outperform mid and large-cap mutual funds.

What are the Advantages of Small Cap Mutual Funds?

Let’s see the benefits of investing in small cap mutual funds -

• Potential for High Growth: As we saw, small cap funds directly invest in companies that are still in the developing and early-stage phases of growth but have the potential for the future. While it certainly brings risk, it also makes these funds an excellent option for high growth.
• Portfolio Diversification: Small cap mutual funds present a great opportunity for you to enhance the mix of your portfolio. This is especially the case if most of your existing investments are low risk. Through such mutual funds, you can invest in multiple companies that are spread out across various industries.
• Lack of Attention by Bigger Institutions So Far: Small-cap stocks get relatively less attention from large institutions and financial advisors, which can make them a great investment option. This can give you the option to invest in companies whose potential is yet to be discovered, which allows for tremendous growth potential over a long time.

Disadvantages of Small Cap Mutual Funds

The most notable downside of small cap funds is their high risk and volatility. As the investment is primarily in growing companies with a small market cap, the risk can be quite high. While many small cap companies have shown returns of over 100% within a year or two, you’ll also find many companies that became bankrupt and lost almost all the investors’ money.

To avoid such pitfalls, it’s advisable to go for the best small cap mutual funds that diversify risk and are run by highly experienced professionals.

Best Small Cap Mutual Funds

In the following table, we have covered some of the top small cap mutual funds in the UAE and around the globe -

How to Invest in Small Cap Mutual Funds?

Here’s a step-by-step guide to investing in small cap mutual funds -

• Step1: Choose a trustworthy financial service provider like a bank or a wealth management firm that provides mutual fund services.
• Step2: Open an investment account by visiting the website of this chosen firm. You can simply visit the website and fill in the required details to register an account.
• Step3: Once your account is officially registered on the website, go through the investment options. You can use filters to get the list of small cap funds as per your needs.
• Step4: Once you've chosen the best small cap mutual funds for you, start investing by filling in the required details and making the payment.

Note: Mutual funds can be purchased in the form of units. You can either make regular investments via SIPs or put in a lump-sum amount.

Things to Remember Before Investing in Small Cap Mutual Funds

Like every other form of investment, small cap funds also hold certain risks. For this reason, even if you’re a seasoned investor, you must keep certain factors in mind before investing in small cap mutual funds -

1- Risk of Investment

Even with the top small cap mutual funds, the risk is considerably higher than that with mid or large cap funds. So while you can find certain funds that balance these risks and generate positive returns, it’s essential to grasp the inherent risk involved. Furthermore, make sure that you're investing in the right small-cap funds.

2- Cost of Investment

This is usually applied in the form of small cap mutual funds expense ratio, just like any other fund. It refers to expenses related to investment management by a professional. Look for funds that have a lower expense ratio.

3- Return on Investment

Small cap funds are known for their high returns. They can be a great addition to your portfolio — with higher risk, you can ensure that these funds are like buffers for your portfolio, providing great value if things go well in the market. So while past performance is not an indicator of the performance ahead, it’s advisable to check the annual small cap mutual fund returns for the last 3 to 5 years.

4- Goals of Your Investment

When the market falls, the performance of even the best small cap mutual funds might suffer. At the same time, if you stay invested for a long period, you can usually get good returns. So if you want to get the best out of your investment, first understand whether you want to go for a long-term investment or a short one.

5- Fund Manager

Considering the higher risk of small cap funds, it’s advisable to go for the top small cap mutual funds that have competent fund managers with a good past record. Go for a seasoned fund manager who has significant experience in managing funds under this category.

6- Portfolio Turnover

This gives an idea of how many times a small-cap fund has sold its holdings over time. Portfolio turnover gives insight into how a fund is managed — if the turnover is modest, you can conclude that the fund manager is confident in the companies in which they have invested.

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