Mutual funds may be classified into three types: debt funds, equity funds, and hybrid funds. Additionally, based on the scheme’s content, every group is split into several sorts of plans. Whenever it relates to equity mutual funds, the market capitalization of the equities the fund invests in is the most important type of segmentation. As a result, a small-cap fund in small-cap companies’ stocks, a mid-cap fund in mid-size companies‘ stocks, and a large-cap fund invest in large businesses’ stocks. Let’s look at what a small-cap fund is and how it varies from other equity funds.
What Is The Small-Cap Fund?
A small-cap fund is a type of stock index mutual fund that invests in stocks with smaller capitalizations. Small-cap funds invest primarily in companies within the bottom 98% of the market by size, often called “small caps” or “microcaps.” In contrast to large-cap funds, which typically have $100 billion or more under management and track an index like the S&P 500®, most small-cap ETFs passively follow indexes such as Russell 2000®. These are generally businesses that are in the early phases of development and want to expand quickly.
Features And Advantages of Small-Cap Equity Funds
Small-cap funds have several features and advantages that make them attractive for investors. Here are some of the key benefits:
High-risk profile since small-cap firms’ stock prices vary a lot when markets are turbulent:
Small-cap firms’ stock prices vary greatly during volatile markets, which may interest investors with an appetite for high risk. However, because small caps are riskier than large caps and less liquid, they offer higher expected returns on average and have more volatility (or day-to-day fluctuations in price). Smaller companies tend not to pay dividends either.
Liquidity is a feature of small-cap equity funds. These funds can be invested in and redeemed as needed
If you want to invest for less than one year, it is better to go with an equity fund that invests in large companies. These funds are typically liquid and can be bought or sold at any time without incurring penalties on taxes.
You can make a one-time or recurring investment in these funds
The fund’s unit price is determined by the net asset value of its assets. Net assets are calculated as the total market value minus liabilities, including debt and preferred securities. That means for a company to have an investment portfolio worth $100 million, it needs only $80 million in equity because it can borrow up to 20% against those investments.
How do small-cap equity funds work?
Investors that invest in small-cap funds have their money bundled into a single pool. The fund manager then invests at least 65 percent of the fund’s assets in stocks and securities of chosen publicly traded businesses that rank 251 or higher on the market valuation scale yet have growth prospects and are cheap. You stand to profit richly from your investments if the market value of the asset assets rises. On the other hand, if the market value drops, you will lose money and experience capital degradation.
Who should consider investing in small-cap equity mutual funds?
Small-cap equity funds are risk-averse investors who are willing to take on a significant level of risk. Small-cap stock mutual funds are another option for investors with a long-term investing perspective, as the risks tend to flatten out over time, and they can offer possibly high returns. If your risk appetite and investment approach match small-cap funds, you may want to explore investing in them.
Things to remember when investing in small-cap funds
1. The charges
Like all other mutual funds, small-cap funds have a Total Expense Ratio (TER) that covers the expenses of operating and running the fund. Before buying, compare the TER of several small-cap equities funds.
2. Investing appropriate time frame
Small-cap funds are appropriate for investors with a mid to long investment horizon since economic uncertainty decreases with time, and small-cap stocks can provide good returns if allowed to expand. Before investing in small-cap funds, consider your investment horizon as well.
3. The risks associated
Small-cap stocks are prone to significant volatility concerns due to their aggressive growth-seeking high volatility risks. A modest market crash might cause these equities’ values to plummet dramatically. As a result, before investing in these funds, you should be thoroughly informed of the investment risks.
4. Return on investment possibility
Small-cap companies may become multi-baggers in a healthy market situation, of course, if firms actively capture the opportunity for development. The risks, on the other hand, are unavoidable. Before investing in small-cap funds, be sure you understand the risk-reward trade-off.
5. Comparative analysis
To choose the best strategy, you must compare several funds. Compare the past performance of several small-cap equities mutual funds. Then choose a strategy that has consistently provided the most significant returns across the various eras.
Taxation of small-cap equity funds
There are no tax advantages to investing in small-cap equities mutual funds. They are included in your taxable income. The earned returns, however, are subject to equity taxes at the time of redemption. The following is how you would be taxed on small-cap fund returns:
- If you redeem the fund after 12 months of investment, you will be subject to long-term capital gains tax. Returns of up to Rs 1 lakh will be tax-free. The excess returns will be taxed at 10% if the returns exceed Rs 1 lakh.
- Short-term capital gains tax will be applied to the returns if you redeem the fund within 12 months. The profits would be taxed at a rate of 15%.
The Bottom Line
If you want to grow your investment portfolio with a product with lower risk than an index fund, perhaps investing in small-cap funds is the right choice. Small caps typically have less liquidity and more volatility but also higher potential returns.