As per SEBI criteria, companies ranked from 251st onwards in terms of market capitalisation and having a market cap range from 300-2000 crore are termed small-cap companies. These are usually new start-ups that have negligible market presence and are yet to prove themselves in the oligopoly market conditions. Small-cap funds tend to invest a majority of the fund corpus in small-cap companies. Although they are quite volatile and risky, the return and growth potential are what attract long-term investors to these mutual funds. But allocation of funds to this category requires research, assessment of your risk appetite, and alignment of your financial objectives before taking the plunge. It is not easy for all to digest the losses that you may incur from small-cap investments.

High Volatility: Not for the Faint-Hearted

Though the return-generating potential of small-cap funds is higher, you must remember that stakes are also higher. These companies are at their initial stages and are destined to go through considerable ups and downs along with market movements. They are not financially or structurally robust like their larger counterparts and are affected by the slightest change in the stock market scenario due to macro and microeconomic changes. Due to this, the price swings are extreme, with difficulties in recovering in bearish markets. Emotional and first-time investors tend to panic in a bear market as they struggle to look beyond returns and lose patience.

If actively managed, with time, these funds can generate above-average returns, which can increase your overall portfolio returns significantly. For instance, Quant Smallcap Fund, which was launched in 2013, claims to have doubled the money invested in it every 3 years and has delivered 18.08 % average returns annually. It has not only controlled losses in a bear market but also delivered returns consistently. So the key to generating returns from small-cap investments is patience and well well-researched time horizon.

Liquidity Risk

With increased risk, these funds usually have lower trading volumes as the impact of market cycles reduces the liquidity considerably. Most investors try to redeem out funds during market corrections or downturns; however, in the case of small-cap funds, it becomes difficult due to their extreme fall with even slight cycle changes. Fund managers are unable to sell stocks at such a low price for the sake of overall corpus returns. In case they are forced to move out of small-cap stocks in large proportions during market corrections, it may affect the mutual funds’ NAV way beyond recovery.

Longer Recovery Time in Downturns

These companies, being new entrants in the market, are low in capitalisation, infrastructure and tend to struggle with low financial reserves. With market falls and macroeconomic downturns, they find it hard to run their daily business process and start to underperform in no time. They also find it difficult to bounce back fast when the market is in an upward swing. After the post-COVID rally in 2020, small caps faced a sharp correction in late 2023, due to SEBI warnings and macroeconomic risks. The BSE small-cap index fell 15 to 20% in a few months. To date recovery scene is mixed with some small-cap stocks still lagging.

Requires a Long Investment Horizon

Besides diversification, time is another important factor that drives investment strategies in small-cap funds. These funds give their best only if you can lend them 7 to 10 years to perform. Definitely not ideal if you are in the market for a quick buck. But beneficial if you are a seasoned long-term market player.

Not Ideal for Conservative or First-Time Investors

To reiterate, before any investment, it is mandatory to assess your strengths and weaknesses as an investor. If you panic easily or do not have the financial strength to incorporate losses in your portfolio, or may have a higher number of dependents in your family, it is prudent to stay with safer options like large caps or flexicap funds, which can generate stable returns. Even for first timers, it may be difficult not to get affected by the heavy downtimes or losses incurred during a highly volatile market. In such cases, consider investing safely or adopting a Systematic Investment Plan or a monthly investment plan for improved returns.

Who Should Consider Small-Cap Funds

The best people who should consider small-cap stocks or funds to invest in must have these characteristics :

  • They must have a high risk appetite and can tolerate losses and stay invested in a bear market.
  • If you already have a sufficient amount of your portfolio in large and multicaps and even in debt instruments, covering your financial safety, you can go for further diversification in small caps to improve your risk-adjusted returns.
  • If time is on your side, you must have a corpus in small-cap stocks with a time horizon of 7 to 10 years, looking beyond the short spells of volatility.

Conclusion

Small-cap funds present opportunities for high returns in a long-term horizon, despite having heightened volatility and risks. Given their reputation for underperformance during market corrections, strategic and timely allocation is necessary to counter volatility. No matter what, again, realignment with your financial goals, understanding your risk capabilities, and engaging a professional and qualified financial advisor can ensure well-researched investment choices in this dynamic segment.