Small-cap Funds: Key Characteristics and Risks

The key to being a progressive investor is having well-balanced diversification in investments. Small-cap stocks form the basis of an investment utopia—small-cap funds that primarily invest in small-cap stocks with a huge scope of potential!

As per SEBI regulations, a small-cap fund is a mutual fund that must invest at least 65% of its investments in small-cap stocks, which aim to generate potentially high long-term returns.

Interestingly, small-cap funds have been able to outperform their benchmarks in these recent downturns, with 26 of 28 active small-cap funds beating their benchmarks.

In this article, we learn the meaning of small-cap funds, their risks and rewards, market cycle performance, sector focus, and suitability for investors.

Understanding Small-Cap Funds

Small-cap funds are equity mutual funds that mainly invest in small-cap stocks that are variable and volatile while carrying a high degree of risk.

These are generally stocks going through a robust growth stage and carrying prospects of long-term wealth generation. In the last 5 years, these small-cap funds have been able to give a bright 30.77% return on average!

Source: Morningstar

Risk vs Reward in Small-Cap Funds

Small-cap funds bring diversification in the form of exposure to different companies that are on their growth journey. These companies are not adequately represented by the large and mid-cap funds. Subsequently, these are generally undervalued and therefore possibly trading at low prices.

These companies have significant growth potential, innovations, and emerging business scope. Therefore, they are likely to generate superior returns in the long term.

While these small-cap funds have the potential to bring significant returns, they come with high associated risks. Market disturbances greatly impact their Net Asset Value (NAV).

Exploring the landscape of small-cap investing can be challenging. In order to understand its potential, investors can compare its risk profile with the associated rewards.

An investor unwilling to witness negative returns in the short term, should not consider investing in small-cap funds. These funds are prone to high risks in the short term and can occasionally face negative returns too. 

Small-cap funds require a long-term investment horizon as these tend to be extremely volatile in the short-term. Small-cap stocks are companies that are usually in the early stages of development or are smaller in size as compared to other sizes and, therefore, have a higher growth curve ahead. The returns on these investments are optimally realised in the long-term. 

These small-cap investments face high liquidity risk, owing to the significant volatility of the small-cap stocks they invest in, as they are not heavily traded in the market.

Market cycle performance

A market cycle refers to the fluctuations in the market. An upswing occurs when the market is performing well and moving upwards. A downturn is when the market is falling. 

A small-cap fund tends to outperform during market upswings, as a result of their rapid growth potential. They provide better return opportunities since the economy is moving upwards and that gives these small companies scalable prospects, thereby boosting fund performance.

During market downturns, small-cap funds tend to suffer. Typically, due to their smaller size and possibly limited experience, these funds appear more vulnerable to market downsides. These drawdowns cause sudden and swift fall in prices of these small-caps, but recovery takes time, and therefore is more challenging.  

Management Style

Generally, small-cap funds are actively managed. Fund managers tend to identify promising stocks from emerging businesses that seem to have the potential to generate superior returns in the future. This is done, keeping in mind the investment objectives of the scheme.

Sector Focus

Small-cap funds allocate funds across different companies that are listed above or at the 251st rank in terms of market capitalisation, on the stock exchange. Their sector allocation is based on market trends, economic conditions, and sector-specific growth opportunities. Additionally, they also account for historical data and future prospects in different sectors. 

Small-cap funds tend to target niche markets capable of offering optimal returns.

Who Should Invest in Small-Cap Funds?

Small-cap funds include a variety of emerging stocks that have the potential to outperform large and mid-cap stocks. However, to determine its suitability for an investor, the following factors need to be considered.

• High-risk appetite:

It is suitable for investors who are willing to take high risks in exchange of potential superior returns. 

• Long investment horizon:
  It is ideal to hold small-cap funds for a longer investment horizon to optimally realise the growth potential associated with the blooming stocks. Therefore, these are more suitable for investors having a long-term investment horizon.
  

Key Metrics for Evaluating Small-Cap Funds

Small-cap funds can be evaluated using:

• Standard deviation: A fund’s standard deviation is a measure of the fund’s volatility. Higher the standard deviation, higher the fund’s associated risk.
• Alpha: Alpha measures the performance of a fund with its benchmark. It evaluates the excess returns generated by the fund over and above the returns of its benchmark. A positive alpha indicates outperformance by the fund.
• Beta: Beta measures a fund’s volatility against its benchmark. A higher than 1 beta indicates the fund is more volatile than its benchmark. A lower than 1 beta indicates the fund is less volatile than its benchmark.
• Sharpe Ratio:  The Sharpe ratio measures the excess returns of a fund over that of the risk-free rate, for every unit of risk taken. A Sharpe ratio of more than 1 is considered optimal for investors.  

To Wrap It Up

Small-cap funds are useful financial instruments that offer diversification and immense growth potential. Moreover, being small in size they usually draw less analyst attention and are therefore generally undervalued. Investors can capitalise on these investment opportunities and benefit in the long term. 

However, their high risk quotient and lower liquidity tend to be genuine concerns for investors. An investor needs to evaluate their own risk profile, and determine expected returns aligned with their investment goals to check if small-cap funds are a good fit for their portfolio!