Why small-cap funds are a hidden gem in mutual fund investments

Small-cap funds are often overlooked by retail investors who prefer the stability of large-cap stocks. However, if you are comfortable taking a little more risk for the possibility of gaining higher returns, small-cap funds may be a real hidden gem.

What are small-cap funds?

As per the Securities and Exchange Board of India’s (SEBI) guidelines, small-cap funds invest in companies ranked below the top 250 by market capitalisation, with a market value of below ₹5,000 crore. While such funds are more volatile, they also offer a unique set of benefits that can add considerable value to a diversified investment portfolio.

What makes small-cap funds attractive?

The major appeal of small-cap funds is their potential to yield high returns. These companies are often in niche or emerging sectors, which allows them to quickly adapt to market changes, launch new products as well as seize fresh opportunities. If these businesses grow and succeed, their stock prices may rise dramatically, resulting in potentially higher returns for investors.

When the overall market is doing well, small-cap funds often outperform large-cap and mid-cap funds. Also, by investing in small-cap companies, you gain exposure to sectors that are usually underrepresented in large-cap portfolios. This adds diversification and increases your chances of better returns in the long run.

Why invest in small-cap funds through an SIP?

While small-cap funds offer strong return potential, they can also be quite volatile. That’s where a Systematic Investment Plan (SIP) helps.

SIPs allow you to invest a fixed amount periodically, which helps average out the purchase cost over time. This strategy cushions you from market fluctuations and helps you remain invested for the long term.

SIPs also benefit from the power of compounding, where your returns are reinvested to earn even more returns. Over time, this can allow your money to grow into a substantial amount. For long-term investors with a higher risk appetite, small-cap SIPs can be a prudent way to build wealth.

What makes small-cap funds rewarding despite their risks, and how can you manage those risks effectively?

Small-cap funds are looked upon as riskier as compared to large-cap or mid-cap funds. But their strong growth potential makes them highly rewarding, particularly for long-term retail investors. These funds invest in smaller, fast-growing companies that have the potential to become tomorrow’s market leaders.

As these companies expand, their stock prices can rise sharply, giving investors the chance to earn much higher returns compared to more established companies. However, small companies can even face challenges. They might be more impacted by economic slowdowns or changes in business conditions.

Their stocks are usually less liquid, which means buying or selling them in large amounts is not always easy. The good news is you can still enjoy the benefits of small-cap funds while managing the risks smartly. Here’s how:

• Stay invested for the long term: Small-cap funds work best if you invest for at least five to 10 years. This gives your investment enough time to grow and helps you ride out short-term ups and downs.
• Diversify your portfolio: Do not put all your money into small-cap funds. Mix your investments with large-cap and mid-cap funds. This way, even if small-caps are down, your other investments can balance the risk.
• Pick the right fund: Choose funds that are managed by experienced professionals who understand how to identify promising small-cap companies. Their research and expertise can make a big difference in selecting the right stocks.

Ending note

Small-cap funds offer a unique chance to invest in tomorrow’s market leaders and high-growth companies. With the right approach, they can generate impressive returns over time.

Investing through SIPs adds discipline, spreads out risk, and leverages compounding to grow your money steadily over time. If you have a long-term outlook and are comfortable with some short-term ups and downs, small-cap funds can be a powerful tool in your wealth-building journey.