What is a Small Cap Fund? Understanding the Basics for High Returns.

Tue, 26 Nov 2024

3 mins

Understand the key aspects of small cap funds for Indian HNIs. Learn about their growth potential, market performance, and tax efficiency to optimize your investment strategy.

In India's rapidly growing investment landscape, small cap funds have gained significant attention among high-net-worth individuals (HNIs) seeking higher returns through aggressive growth strategies. Small cap funds are mutual funds that primarily invest in companies with smaller market capitalization, typically under Rs. 5,000 crore. These companies, though smaller in size, often have high growth potential and can provide substantial returns over time.

In this blog, we will explore the basics of small cap funds, their performance in the Indian context, and how they fit into the wealth management strategies of HNIs.

• What are Small Cap Funds?

  Small cap funds focus on investing in companies that rank beyond the top 250 in terms of market capitalization. These companies are typically at the early stages of development, making them riskier investments compared to large and mid cap companies. However, their relatively small size allows for higher growth potential, which can translate into significant returns for investors who are willing to embrace the risk.
   

  • Market Capitalization: Small cap companies generally have a market capitalization of less than ₹5,000 crore. While they are more volatile, they offer the potential for higher returns compared to large cap stocks.
  
  
  • Volatility: Due to their size, small cap stocks are more susceptible to market fluctuations. Economic downturns or unfavorable market conditions can affect small cap stocks more drastically than their larger counterparts.

• Performance of Small Cap Funds in India

  Historically, small cap funds have outperformed large and mid cap funds during bull markets. For instance, during the market recovery after the COVID-19 pandemic in 2020-2021, small cap funds witnessed an extraordinary rally, delivering returns in the range of 60% to 100% in some cases.
  
  However, the volatility that comes with such high returns is something that investors need to be prepared for. In bear markets, small cap funds can suffer significant losses. Over the long term, small cap funds tend to offer average returns of 12% to 15% annually, according to AMFI (Association of Mutual Funds in India).
  
  Stat: In 2023, small cap funds have recorded an average return of 13% YTD (as of August 2023), outperforming large cap funds, which delivered returns of 9%.
  

• Key Benefits of Small Cap Funds for HNIs

  • High Growth Potential: Small cap companies often have room for expansion, and early investments in these firms can yield considerable capital appreciation as they grow.
  
  
  • Diversification: Investing in small cap funds allows HNIs to diversify their portfolios. While large cap stocks provide stability, small caps can deliver the necessary growth component.
  
  
  • Undervalued Opportunities: Many small cap stocks are undervalued compared to their larger counterparts. HNIs who can identify these hidden gems early can potentially benefit from significant upside.

• Risks Associated with Small Cap Funds

  Investing in small cap funds is not without its risks. Due to their volatility, small cap funds can experience drastic swings in value, particularly in times of economic uncertainty. These funds are best suited for investors with a long-term investment horizon and a higher risk tolerance.
   

  • Market Sensitivity: Small cap funds are more sensitive to market downturns and can experience sharper declines than large cap funds during bear markets.
  • Liquidity Issues: Small cap stocks may also face liquidity challenges, as they tend to have lower trading volumes. This can make it difficult to exit positions during market corrections.

• Who Should Invest in Small Cap Funds?

  Small cap funds are generally suited for HNIs who have a long-term investment horizon (typically 5-10 years or more) and are comfortable with higher levels of risk. These funds are ideal for investors looking to capitalize on growth opportunities in emerging sectors and industries.
  
  For HNIs in India, sectors such as technology, consumer goods, and renewable energy present promising opportunities for small cap investments, as companies in these sectors are poised for exponential growth.

• Tax Implications

  Like other equity mutual funds, small cap funds are subject to capital gains tax. 
  
  Short-term Capital Gains (STCG): 20% tax applicable to units held for less than one year, effective for assets sold on or after 23rd July 2024.
  
  Long-term Capital Gains (LTCG): Gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5% without indexation, effective for assets sold on or after 23rd July 2024.

• To sum it up

  Small cap funds present an exciting investment opportunity for HNIs in India, offering significant growth potential but accompanied by higher risk and volatility. For those looking to diversify their portfolios and willing to ride out the market fluctuations, small cap funds can be a valuable addition to a long-term wealth management strategy.
  
  If you need any further assistance you may reach out to us at 8047593769 or open your account, and we can help you start your investment journey.  

• Sources

  • AMFI Small Cap Fund Data
  
  
  • Economic Times Small Cap Funds Performance
  
  
  • Morningstar India Market Reports