Small-cap Fund
A small-cap fund is an equity mutual fund that invests largely in stocks of small-cap companies, typically those ranked 251st and below by market capitalization in India. These funds target emerging businesses with strong growth potential but higher volatility, making them suitable for long-term, high-risk investors.
In India, small-cap funds usually maintain at least 65% exposure to small-cap stocks as per SEBI category norms, which can lead to higher upside and higher drawdowns.
Small-cap allocation rule
SEBI classifies small-cap companies as those ranked 251st and below by full market capitalization. A small-cap fund must invest a minimum 65% of its equity assets in this universe to stay within the category.
- Category rule: At least 65% in small-cap stocks.
- Ranking method: Market-cap rankings are based on the full market capitalization list.
- Implication: Fund returns can differ sharply from large-cap or index funds.
How small-cap funds work
The fund manager builds a portfolio of small-cap stocks, typically those ranked below the top 250 companies by market capitalization in India. Returns depend on business growth and market sentiment.
Portfolio selection
Funds screen for companies with strong growth potential, improving profitability, and scalable business models.
Higher volatility
Small-cap stocks can move sharply during market cycles, which increases both upside potential and downside risk.
Why investors choose small-cap funds
- Growth potential: Small companies can expand faster and deliver higher long-term returns.
- Early-stage opportunities: Exposure to businesses that could become future mid or large caps.
- Diversification: Adds a growth sleeve to a broader equity portfolio.
- Long-term compounding: Works best when held for extended periods.
Key risks to understand
- High volatility: Returns can swing sharply in short periods.
- Liquidity risk: Smaller stocks may be harder to buy or sell quickly.
- Business risk: Small firms may have less stable cash flows and higher competition risk.
- Cycle sensitivity: Small caps often underperform during market stress.
Higher growth, higher risk
Small-cap funds can deliver strong growth but require patience and risk capacity.
Long-term focus
A longer holding period helps smooth short-term volatility.
Diversified exposure
Mutual funds spread investments across multiple small caps to manage risk.
Who should invest and for how long
Small-cap funds are best suited for investors with a high risk tolerance and a long investment horizon. A time frame of 5 to 7 years or more improves the chances of riding out volatility.
- Risk profile: Aggressive or growth-focused investors.
- Time horizon: Long-term goals like wealth creation or retirement.
- Allocation: Use as a portion of equity allocation, not the entire portfolio.
Common small-cap fund mistakes
- Short-term expectations: Small caps can be volatile; avoid judging performance in months.
- Over-allocation: Too much exposure can raise portfolio risk beyond comfort.
- Chasing recent winners: Past returns do not guarantee future performance.
- Ignoring risk profile: These funds are not suitable for conservative investors.
Who should consider small-cap funds
- Investors with a long time horizon and high risk tolerance.
- Those building a diversified equity portfolio with growth potential.
- Investors comfortable with market volatility and interim drawdowns.
- People investing for long-term goals such as retirement or wealth creation.