What is Small Cap Mutual Funds?
Small cap mutual funds are equity schemes which are required to invest a minimum of 65% of their total assets in the equity of small cap companies. Small cap companies are the 251st company downwards in terms of market capitalization. A company’s market capitalization is the market value of its outstanding shares. Aggressive investors with a high appetite for risk can invest in small cap funds in order to maximize their wealth.
Advantages of investing in small cap funds
- Higher growth potential – Small cap funds typically have the highest growth potential since the underlying companies are young and seek to expand aggressively. These companies have the ability to grow at a greater scale than larger companies.
- Undervalued investments – Usually small cap companies have very little analyst coverage because they are under-reported and undiscovered. As a result, there is a large probability of these companies being undervalued and thus, can be a great investment opportunity.
- Diversification benefits – When considering your overall portfolio, adding small cap funds helps you to balance the risk-return trade-off and diversify, thereby reducing overall risk.
- Merger and acquisition possibility – There is a great likelihood that small cap companies may get acquired by their larger counterparts to grow inorganically and this could cause a significant upside in the share price of smaller companies eventually adding value to small cap funds.
- Low liquidity – Small cap companies tend to be thinly traded and though this is viewed as a drawback by some, it could prove to be advantageous for investors who could foresee the potential of the company. As the company’s earnings and revenue become visible, investors start chasing the shares of such companies and since there are a limited number of shares available publicly, the share price rises rapidly.
Disadvantages of investing in small cap funds
- Risky – In the event of an economic or business downturn, many small cap companies are not able to survive among their more competent larger counterparts and as a result, value of investment in small cap funds can go down drastically. Therefore, they are not a suitable investment for risk-averse investors.
- Highly volatile – Whenever market sentiment turns weak, stocks of small cap companies are punished harshly causing great volatility in their share prices. This can cause small cap schemes to bleed.
- Do not pay dividends – Since most small cap companies are young and need to reinvest their earnings in order to grow their business, they are unable to pay dividends. Thus, you cannot rely on dividend payments as a source of income.
Though Small Cap Mutual Funds have their own set of problems, as pointed out above, the biggest upside of investing in small cap funds is the significant growth potential, which cannot be matched by their larger counterparts. When chosen correctly, small cap funds can improve the performance of your overall portfolio without adding a great degree of risk. Therefore, it is not advisable to avoid investing in them completely as you may miss out on their potential to generate high returns. At the same time, you should exercise due diligence in selecting the right type of mutual fund investment with a proven track record and trustworthy management.