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In the last three years, small cap funds have given 40% return. This might entice any one to invest in these funds. However before flowing to it like a moth gets drawn to a flower, you should know what small cap funds are. What’s the reason for robust returns in these funds and what kind of investors should invest in it.

Small cap funds invest around 65% of their capital in small cap shares or equity instruments related to them. Meaning these funds pick stocks that are small in size and are new. The benefit of investing in them is you can ride the wave to success as these shares grow. This helps in getting massive returns.

Risky business

Small cap funds give good return but they are very risky because they are quite volatile. Generally, it takes time for small companies to grow. Besides this, small cap shares are impacted by change in market, no matter how small. An investor should choose a small cap fund on the basis of his risk appetite and investment horizon. Generally you need a high risk appetite and long investment horizon to invest in a small cap fund. So it is good for risk-lover investors having long term horizon.

Small-cap mutual funds are taxed similar to equity mutual funds. If you redeem the units of your equity fund within one year of purchase, you incur short-term capital gains. Regardless of your income tax bracket, there is a 15% tax on the gains from these funds. Holding units in an equity fund for more than one year incurs long-term capital gains. However, gains up to Rs. 1 lakh are tax-free, and for gains above Rs. 1 lakh, you are required to pay tax at a rate of 10% and you do not receive the benefit of indexation.

Outpeforming index

In terms of returns, small cap funds have outperformed S&P BSE 250 small cap index benchmark in the last 5 and 10 years. In the last three years, these funds have given 40% return. However, a big reason for this is base effect. Three years back in 2020, the market was in the dumps because of covid. For example, quant small cap fund fell 44%.

Many times, when the market conditions are favourable, small-cap funds outperform other equity-oriented funds. It is often observed that when they grow, your investment grows rapidly, but when they decline, the losses are significant as well. This is why they carry a higher risk. Small companies tend to underperform in bearish markets because they lack sufficient financial resources to navigate challenging market conditions. Therefore, these funds experience significant volatility.

According to the data from the Association of Mutual Funds in India, the investments in small-cap funds were Rs. 2,255.85 crore in January 2023, Rs. 2,246.30 crore in February, and Rs. 2,430.04 crore in March. Similarly, the figures show that the net assets under management of small-cap mutual funds have increased by up to 25% in the one year until March 2023. Small-cap funds are attracting young investors, and this is because there is an increasing awareness about financial instruments among millennials. In the next 5 to 7 years, young investors will have financial resources that will enable them to withstand the fluctuations in these funds. This will allow them to plan for long-term objectives such as retirement and their children’s education.

If an investor wants to invest in a small-cap fund, they should not only focus on the fund’s returns but also compare its returns with its benchmark performance before making any decisions. Financial experts also advise investing in small-cap mutual funds through a systematic investment plan (SIP). Before investing in these funds, one should consider their objective, risk appetite, and investment horizon. It is recommended to allocate a small portion of one’s portfolio to small-cap funds to minimize the possibility of significant losses.