Should You Invest In Small-Cap Mutual Funds?

Small-Cap funds are one of the categories of equity mutual fund schemes for investors to create wealth. A proportionate investment in such a scheme as part of one’s overall portfolio can help boost your collective investment return, thereby aiding in reaching one’s financial goals. However, investors need to be mindful of the risks associated with small-caps and be ready to get invested from a long-term perspective.

Understanding Small-Cap Category
Small-cap stocks are companies listed on the stock exchanges that are smaller in size when it comes to their market capitalisation (M-Cap). Typically, the M-Cap of these companies is not above ₹10,000 crore, while a majority are under the ₹5,000 crore mark. These companies are relatively much smaller in size and operations compared with the biggies of the market, but they have significant growth potential. Having said that, small-cap companies are not to be misunderstood as start-ups. In fact, many small-cap companies have well-established businesses and strong track records in their financial performance

Benefiting from Small-Cap Investing
Investing through mutual funds is one of the best ways to unleash the potential that small-cap stocks offer. These schemes not only endeavour for inflation-beating and benchmarkbeating returns but also yield better risk-adjusted returns. Small-cap equity schemes invest only in the universe of small-cap stocks and help investors gain from the massive potential with its well-researched and process-oriented investment management. Historically, small-cap strategies have outperformed every other category of the equity schemes. For instance, in the 10-year period, the CAGR of the category stands at 19.2 per cent, for five years at 13 per cent and for three years at a whopping 33 per cent. 

Risks and Benefits of Small-Cap Investing
As is valid with any investment, small-caps also have their fair share of risks and benefits. The past performance of small-cap stocks and schemes does look tempting to investors, but one needs to be mindful of the risks and rewards associated with small-cap investing.
■ Risks — Risks associated with small-cap stocks are probably the highest among all the equity categories. A factor that makes them a risky investment proposition is the relatively low probability of them turning successful over time. This makes the stocks of these companies very volatile in nature and thus not suitable for risk-averse or conservative investors. Further, historical charts suggest that small-cap companies often have a long history of underperformance, and there are certain phases when they turn out to be tremendous outperformers.
■ Benefits — As is often said, high risks often culminate into more significant rewards. Similar is the case with small-cap investing. If the right stocks are picked in the portfolio after intensive research and analysing the future potential, small-cap companies can considerably reward investors with returns no other equity category could match up with. You never know if you are investing in companies that would be the stock market’s future gems. A close look at some of the largest companies will give you an idea that once they too were small-sized companies which grew over time. 

Investment Pointers
Given the risks mentioned above and the benefits associated with small-cap stocks, you may consider the mutual fund route as your preferred way of taking exposure to small-cap names. Following are a few pointers you should keep in mind while investing in a small-cap fund:
1. Don’t expect past returns. The past performance of such schemes should not be the only parameter.
2. Extreme volatility is part and parcel of small-cap stocks. Avoid exiting if the valuations of your investment go on a roller-coaster ride. Stay put, as volatility is a trait of small-cap stocks.
3. Ideally, investors with a high-risk appetite should consider investing in small-cap schemes. Low to moderate risk takers may consider giving this category a miss.
4. Investors who have a tenure of not less than five years should invest in small-cap funds. Such investments may test your patience with longer than usual underperformance. Thus, it is advisable not to align investment in small-cap funds with any short-term financial goals.

The writer is Director, WealthFirst Portfolio Managers Ltd ■ Email : ashish@wealthfirst.biz ■ Website: www.wealth-firstonline.com