Talking about Equity Mutual Funds, it is important to understand the market capitalization of companies. In simple terms, market capitalization is the value of the company which is traded in the stock exchange. The calculation is simple – you multiply the present share price by the total number of outstanding shares. It is an important aspect which can help investors determine the returns from a share and the risks involved. Based on market capitalization, mutual fund schemes are categorized as large-cap, mid-cap, small-cap, and multi-cap schemes. Here, we will explore Small Cap Mutual Funds and talk about various aspects that you need to know before investing in them.
What is Small-Cap Mutual Funds
Small-Cap Funds invest a major portion of their investible corpus into equity or equity-related instruments of small-cap companies. According to the Securities and Exchange Board of India (SEBI), small-cap schemes need to invest at least 80% of their total assets in small-cap companies. Also, SEBI defines small-cap companies as those which are ranked below the 250th rank in terms of market capitalization. In monetary terms, these are companies with a market capitalization of less than Rs. 500 crores.
It is important to note that small-cap funds carry a high level of risk. Even the slightest volatility in the market can have a huge impact on the share prices of small-cap companies. However, these stocks also have a huge potential to offer amazing returns. Think about it – a small company has a lot of scope for growth and when it does grow, the share price would increase dramatically. However, many investors tend to turn towards small-cap schemes for short-term investment needs. This can be counterproductive as small companies need time to grow. Hence, it is usually recommended to opt for small-cap funds if you have a higher risk tolerance and a long investment horizon.
Invest in Small Cap Equity Funds
One thing is clear, you should opt for Small Cap Mutual Funds only if you have higher risk tolerance. Usually, many investment advisors recommend investors to dedicate a small portion of their portfolio towards small-caps. This is because small-cap stocks offer a great opportunity to earn huge returns. It is important to be patient while investing in small-cap schemes. Remember, small companies can need time before they become the next large corporation in the country and help you earn great returns on your investment.
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Consider these aspects before investing in Small Cap Funds
As an investor, you must take the following aspects into consideration before investing in a small-cap fund:
Risk and Returns of Small-Cap Funds
The Net Asset Value (NAV) of a Small Cap Fund is highly sensitive to the movements of its underlying benchmark. Hence, when the market conditions are not good, many small-cap funds suffer losses. Having said this, it is also a great opportunity for investors who are willing to take the risk and desire aggressive growth.
In recent years, the small-cap category has witnessed phenomenal growth in India. Small Cap Funds have the potential to offer returns of more than 100% in a single day!
Opt for a scheme with a lower-Expense Ratio
If you are new to investing, then you need to understand the concept of Expense Ratio.
Every fund house incurs a cost to manage your funds. It recovers this cost by charging a fee called Expense Ratio. This is a percentage of the total assets of the scheme. Further, SEBI has mandated an upper limit on the expense ratio – 2.50%.
Since this eats away into your returns, it is important to choose a scheme with a lower expense ratio.
Small-Cap Funds are better in the long-term
Small-Cap stocks are highly sensitive to market movements. Therefore, when the market slumps, these stocks are probably the worse-affected. Hence, it is important to have a long-term investment window while investing in Small-Cap Funds so that you give sufficient time to your investment to generate returns. The recommended time frame is eight to ten years.
Not for the Risk-Averse Investor
Small Cap Funds offer great potential to earn benchmark-beating returns. However, these are highly risky investments and should be considered only if you can stomach the volatility in prices. Further, you can dedicate a small portion of your portfolio to small-caps and stay invested for a long period to boost your wealth creation efforts.
What about tax?
The returns on Small Cap Funds are subject to capital gains tax (for any capital gains made) and Dividend Distribution Tax or DDT (for any dividend received).
Dividend Distribution Tax (DDT)
Before paying out the dividend, the fund house has to deduct a DDT of 10%.
Capital Gains Tax
Capital gain is the profit made from selling an investment. Hence, when you redeem the units of the Small Cap Fund and make profits, you are liable to pay capital gains tax. The rate of this tax is dependent on the period for which you were invested in the scheme – the holding period.
If you were invested in the Small Cap Fund for a holding period of less than one year, then the capital gain earned by you is called Short Term Capital Gain or STCG. This is taxed at 15%.
If you were invested in the Small Cap Fund for a holding period of more than one year, then the capital gain earned by you is called Long Term Capital Gain or LTCG. LTCG of up to Rs. 1 lakh is not taxed. Any gain above this amount is taxed at 10% without indexation.