Why You Should Play a Long Innings with Small-Cap Funds

AMFI (Association of Mutual Funds of India) divides listed companies into three categories based on their market capitalisation[1].
Apr 2023
7 mins read
Large-cap companiesCompanies ranked from 1-100 by market capitalisation
Mid-cap companiesCompanies ranked from 101-250 by market capitalisation
Small-cap companiesCompanies ranked 251 and below by market capitalisation

More than 4,500 small-cap companies are currently listed on Indian stock exchanges[2]. This number is steadily growing, with a slew of recent IPOs. If you want to invest in these companies, you can choose small-cap mutual funds, which offer a diversified portfolio of small-cap stocks.

How small-cap funds work
Small-cap mutual funds are equity mutual funds that invest at least 65%[3] of their corpus in stocks and securities of small-cap companies. The remaining 35% can be invested in the equity of large- or mid-cap stocks or even in debt instruments, depending on the fund’s investment objective (the exact composition is defined in the fund’s Scheme Information Document, or SID)

Why invest in small-cap funds?
The biggest attraction of small-cap mutual funds is their return potential. In a market rally, small-cap funds have the potential to deliver benchmark-beating returns.
Have a look at their recent performance:

Category average CAGR of small-cap funds (as of 31st December 2021)[4]1 year – 62.80%
3 years – 27.67%
Returns from S&P BSE 250 Small-cap TRI[5]56% in 2021

Small-cap funds thus offer investors an avenue for capital appreciation. In an economic recovery, small-cap stocks can deliver strong returns. As the index grows, small-cap funds hold considerable potential for investors looking to create and build their wealth.

Small-cap funds and the value of time
To make the most of small-cap funds, you need to be patient. Here’s why it pays to stay invested for a long period of time:

  • To reduce the inherent volatility
    Small-cap funds are prone to considerable market volatility, as mentioned earlier. With a long-term investment horizon, you are better placed to beat any short-term volatility and potentially earn good returns. This is because, with time, the investment risks even out as fund managers recalibrate and bet on the best stocks which can be profitable in the long run.
    If you study the performance of the small-cap index, you will find bouts of short-term volatility with continued growth over the long-term horizon.

    Source: Economic Times

    This graph shows that from 2005-2014, small-cap funds moved in tandem with the Nifty Small-Cap Index. Thereafter, the funds have outperformed the benchmark index in most years. Even the dip in 2020 caused by the pandemic was quickly followed by a jump as the economy recovered.
    A look at the performance of the various indices in recent years is also revealing:

    Source: Personal FN

    In 2011, 2013, 2018 and 2019, the small-cap index did dip into the red. However, the index recovered and posted positive returns with time, often beating the large-cap and mid-cap index returns. This goes to show that you must stay invested for a while to mitigate the risks of small-cap investment and to see your portfolio deliver returns.

  • To allow compounding to work its magic
    Compounding gives you returns on previous returns and helps enhance the value of your portfolio. However, you need to give your mutual fund investments time for compounding to take effect. If you stay invested over the long run, your corpus could grow exponentially as compounding works its magic.

    Here's an example:
    Say, you invest Rs 10,000/month in a SIP of a small-cap fund today and get an average CAGR of 12%. This is how your corpus would look in 5, 10, 15 and 20 years.
Corpus after 5 yearsCorpus after 10 yearsCorpus after 15 yearsCorpus after 20 years
Rs. 8,11,036
 Rs. 22,40,358
Rs. 47,59,313
Rs. 91,98,573
Disclaimer: This table is for illustration purposes.

If you compare the corpus after 5 years with the corpus after 10 years, you’ll see that the amount has grown almost threefold with just a gap of 5 years. Therefore, staying invested is the key to wealth maximisation.

  • To unlock the true potential of your investment
    Small-cap companies are newly established companies that typically have less historical data and shorter track records than large-cap or mid-cap companies. As a result, fund managers have to take a call on picking equity with limited data available to them. Some of these companies then merge with a larger company, and some explode in growth. But, unfortunately, some don't perform as expected and fizzle out.
    With time, however, small-cap companies can hit their stride, and drive growth in any fund that invests in them. With more time and data, fund managers begin to make better, more informed decisions on increasing or decreasing their investment in small-cap equity or exit it altogether. Thus, when you remain invested in a small-cap fund, you give it time to unlock its true return potential.

  • To avail of tax benefits on long-term capital gains
    Like other equity funds, small-cap funds also provide tax benefits on long-term capital gains if you stay invested in them for 12 months or more. After 12 months of investment, the returns that you earn are tax-free up to Rs. 1 lakh. Even if the returns exceed Rs. 1 lakh, tax is applicable on the excess at a marginal rate of 10%, even if you are in the higher tax bracket[6]. Therefore, small-cap funds can deliver tax-efficient returns if you stay invested and have a long-term horizon.
Small-cap funds are high-risk and high-return potential funds. When you give them time, they have more scope to smooth out the risks and potentially offer higher returns. Tap into the high return potential of these funds with a long-term horizon.

Disclaimer: mutual fund investments are subject to market risks, read all scheme-related documents carefully.

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