Small Cap Mutual Funds: Meaning, Benefits & How to Invest

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Investing can seem overwhelming, especially for beginners who are looking to grow their money. Small cap mutual funds offer one way to earn higher returns, but they have higher risks as well. These funds invest in smaller companies that are not ranked among the top 250 by market size. While they can be more volatile, they also have strong growth potential over time.

This guide explains what small cap mutual funds are, how they work, and what to consider before investing. Even if you’re new to investing or exploring new options, this will help you make informed decisions.

Understanding Small Cap Mutual Funds

These mutual funds focus on investing in businesses that fall outside the 250 largest publicly traded companies in India based on their market value. As per the regulation, these funds must invest at least 65% of their assets in such smaller companies. While they offer greater growth potential than larger established companies, they also carry higher investment risks.

Key Characteristics of Small Cap Funds

Company Focus – Targets growing businesses that haven’t yet reached large-cap or mid-cap status
Growth Potential – Invests in companies operating in specialised or developing market segments
Investment Volatility – It experience more significant price fluctuations than blue-chip investments

Small cap funds can deliver strong returns but require patience and understanding of their sensitivity to market conditions. They typically suit investors with longer time horizons who can bear short-term market movements.

Features of Small Cap Equity Funds

These funds have unique features that set them apart from other equity investments.

Higher Growth Potential: Small cap funds target companies that can grow faster than established large-cap firms. These businesses are in expansion mode and operating in niche sectors like specialty manufacturing, new technologies, or innovative consumer products. However, they offer the possibility of greater returns but also carry increased risk since they haven’t yet proven their long-term stability.
Regulatory Safeguards: SEBI mandates that these funds maintain at least 65% allocation to small cap stocks while limiting exposure to any single company. These rules ensure proper diversification, reducing concentration risk while still allowing fund managers to capitalise on opportunities across different sectors.
Greater Price Swings: Shares of smaller companies tend to have more dramatic ups and downs than those of well-established corporations. They tend to decline more during market downturns but often lead recoveries when conditions improve. This makes them suitable only for investors who can tolerate short-term fluctuations in pursuit of long-term growth.
Requires Skilled Management: Fund managers play a crucial role in identifying promising businesses. Successful small cap investing requires thorough research to uncover undervalued companies with strong fundamentals before they become widely recognised.
Long-Term Investment Horizon: These funds work best with systematic investment approaches (SIPs) held for 5-7 years or longer. The extended timeframe helps smooth out market volatility and allows investors to benefit from the compounding growth of successful small companies as they mature.

Step-by-Step Process to Small Cap Mutual Fund Investments

Investing in small cap mutual funds is straightforward, with multiple options to suit different investor preferences. Here are the primary ways to invest:

1. Direct Investment

You can invest directly through the Asset Management Company (AMC) that manages the fund. Most fund houses allow online investments through their websites, where you can:

Compare different small cap funds
Complete KYC (if not already done)
Invest via lump sum or SIP

This method avoids distributor commissions, potentially lowering costs.

2. Through Financial Advisors/Distributors

For personalised advice, consult a SEBI-certified financial planner:

Assess your risk tolerance and goals
Recommend suitable small cap funds
Assist with paperwork and portfolio tracking
Provide ongoing monitoring

This option is useful for beginners or those who want personalised advice.

3. Online Investment Platforms

Platforms like Groww, ET Money, or Zerodha Coin offer a convenient way to invest:

Compare funds across AMCs
Start SIPs with minimal documentation
Track performance in a single dashboard
Access research tools and ratings

These apps make investing accessible, even for first-time investors.

Investment Modes

After selecting a fund, you mainly have two primary investment approaches:

Lump Sum: A one-time investment (ideal if you have surplus funds and believe the market is favorable).
SIP (Systematic Investment Plan): Regular, fixed-amount investments (e.g., monthly). SIPs help average costs and reduce timing risk, making them a safer choice for volatile small cap funds.

Benefits of Investing in Small Cap Mutual Funds

Small-cap funds can give your investments a nice boost if you’re okay with some ups and downs along the way. These factors make them potentially attractive investment options:

1. Chance to Invest in Future Big Companies

Small cap funds put money into smaller companies that are still growing. Certain businesses in this category have the potential to develop into major industry players over time. By investing early, you get the opportunity to grow your money as these companies expand.

2. Less Competition from Big Investors

Most large mutual funds and foreign investors focus on big companies. Small cap stocks often get overlooked, which means you might find good investment opportunities before they become expensive.

3. Quicker Recovery After Market Dips

Small companies can adapt faster when the economy improves. This means they often bounce back quicker after tough times, sometimes even doing better than larger companies when markets recover.

4. Better Tax Treatment for Long-Term Investors

If you hold small cap funds for more than a year, any profits above ₹1 lakh are taxed at just 10%. This makes them more tax-friendly than many other investment options for long-term goals.

5. More Room to Grow

A small company growing from ₹500 crore to ₹1,000 crore is easier than a huge company doubling in size. Small cap funds invest in these smaller businesses that have more potential to expand quickly.

6. Access to New and Growing Sectors

Many small companies work in exciting areas like:

Electric vehicle parts manufacturing
New technology like AI and renewable energy
Innovative consumer products and services

Ideal Investor Profile: Who Should Invest in Small Cap Mutual Funds

Small cap mutual funds are not for everyone. They suit investors who can handle higher risk and volatility in exchange for potentially higher long-term returns. Here’s a quick overview of who should consider them:

Parameter	Ideal Fit	Not Suitable For
Investment Horizon	Hold for 7+ years to manage ups and downs and gain from growth phases.	Those needing money within 3-5 years
Risk Appetite	High tolerance for short-term losses (can handle 30-40% declines temporarily)	Conservative investors who panic during market falls
Financial Goals	Wealth creation (not for emergency funds or fixed expenses)	Capital preservation or regular income needs
Investment Style	Disciplined SIP investor (avoids timing the market)	Traders looking for quick profits
Portfolio Allocation	10-15% of total equity portfolio (balanced with large/mid-caps)	Those putting all savings in small caps
Behavior	Patient, ignores short-term noise, stays invested during downturns	Emotional investors who check portfolios daily
Tax Bracket	Investors who benefit from LTCG tax (10% over ₹1L after 1 year)	Those in highest tax brackets needing tax-free returns

Taxation Rules of Small Cap Mutual Funds

Taxation Rules for Small Cap Mutual Funds:

Holding Period	Tax Type	Rate	Taxable Amount	Important Notes
Less than 12 months	Short-Term Capital Gains (STCG)	15%	Entire profit	Applies to each sale transaction
More than 12 months	Long-Term Capital Gains (LTCG)	10%	Gains above ₹1 lakh/year	No indexation benefit available
Dividend income	–	As per the income slab	Full dividend amount	Taxed in the year of receipt

Key Points:

Each SIP payment you put in has its own separate 1-year timer for tax purposes
LTCG benefit applies across all equity funds collectively (not per fund)
Dividends get added to your income and are taxed at your normal rate
The government won’t take out any tax when you withdraw your investment profits

Conclusion

Small cap funds aren’t for everyone, but they can be rewarding if you understand what you’re getting into. The smart approach? Start small through SIPs, be prepared for bumpy periods, and give your investments at least 7 years to work. Remember, even the best small cap funds will have tough years and that’s normal.

Before investing, always check if these funds match your money goals and risk comfort. If you are looking to capitalise on the growth of small companies and have the patience to ride out market fluctuations, small cap mutual funds could be a valuable addition to your portfolio. So, it is crucial to stay informed, regularly review your investments, and consult with a financial advisor to ensure that your choices align with your personal goals.