Some years ago, a friend’s son wanted to know if he should invest all his investment savings in small-cap funds as they seemed to be yielding maximum returns at that point in time. I told him that returns must be reviewed over longer time frames and not just the last 12 months and also suggested that while in terms of Life-Cycle investing, Small Cap funds might be more suited for a person of his age, putting all his eggs in one basket might not be optimal as diversification is one of the keys to building an all-weather portfolio.
The Securities and Exchange Board of India (SEBI) defines small-cap companies as those which are ranked below the 250th rank in terms of market capitalisation. In the Mutual Fund space, Small-Cap Fundsare those that invest a major portion of their investible corpus into equity or equity-related instruments of small-cap companies. As per SEBI’s definition, small-cap schemes need to invest at least 65 per cent of their total assets in small-cap companies.
The key factor here too is diversification. Rather than investing directly in a handful of small cap stocks, mutual funds spread investments across numerous companies and sectors. This reduces company-specific risk while enabling investors to benefit from professional research and portfolio management. Fund managers continuously evaluate business fundamentals, management quality, and growth prospects before making investment decisions.
Investors should also avoid selecting funds solely based on recent high returns. Evaluating the fund house's investment process, consistency across market cycles, portfolio quality, and the fund manager's track record is equally important.
Systematic Investment Plans (SIPs) can be particularly effective when investing in small cap funds. By investing a fixed amount regularly, investors benefit from rupee cost averaging, purchasing more units when markets decline and fewer when markets rise. This disciplined approach helps reduce the impact of market volatility over time.
It is worth noting that every large company was once a small company with a dream. While not every emerging business becomes the next industry leader, many of today's market giants began as relatively unknown enterprises. Small cap mutual funds are built on this simple idea—identifying businesses with the potential to become tomorrow's success stories. The journey, however, is rarely smooth, demanding patience, discipline, and the willingness to look beyond short-term market fluctuations.
The periodic popularity of small cap funds also calls for caution. Strong past returns often attract fresh inflows just when valuations have become expensive. Investors should remember that yesterday's top-performing category may not necessarily lead tomorrow's returns. Chasing recent performance has rarely proved to be a successful investment strategy.
It is important for investors to be cognizant of the fact that small-cap funds carry a higher level of risk than many of the SEBI defined categories. Even the slightest volatility in the market can have a huge impact on the share prices of small-cap companies. Hence, one must tread with caution.Even more importantly, an assessment of the suitability of a small cap fund based on life cycle stage must be undertaken before investing.
Clearly, there are returns to be made in small-cap funds, but one must be discerning in its selection and have the twin qualities of risk-bearing appetite and patience.
(Ashok Kumar is an experienced investor. He can be contacted at ceolotus@hotmail.com)
