The role of small cap funds in portfolio diversification: Best practices for investors

It is true that small-cap funds pose a higher risk to your investment portfolio; however, you can leverage these investments to earn higher returns in the long term. Know about the advantages of small-cap funds and how you can invest in these funds in this article.

What are small-cap funds?

Small-cap mutual fund schemes invest in funds that have a relatively low market capitalisation. A company’s market cap is the total value of its outstanding shares. Small-cap funds are generally more volatile as compared to large- and mid-cap funds and therefore pose higher risks to investors. A mutual fund house must invest at least 65% of its corpus in small-cap funds. The Securities and Exchange Board of India (SEBI) considers companies ranked 251 and beyond by full market cap as ‘small-cap companies’. Small-cap funds invest primarily in these companies.

Advantages of small-cap funds:

Here are the key advantages of investing in small-cap mutual funds:

• You can diversify your portfolio by investing in small-cap funds: The primary advantage of investing in small-cap funds is the ability to diversify one’s investment portfolio. Large-cap funds are generally dominated by heavyweight sectors like FMCG (fast-moving consumer goods) and finance. Small-cap funds can help you gain newer exposure to the market and thereby diversify your portfolio.  

• Small-cap funds are ideal for long-term investors: If you are investing for the long term, small-cap investments are for you. These mutual fund schemes help investors earn exponentially high returns over long periods (for instance – 10 to 15 years). You can invest regularly in small-cap funds to leverage Rupee-Cost Averaging and inculcate an investment discipline.

Best practices for investors:

• Rely on funds that have produced high returns in the recent past: You can find several small-cap funds that have produced high returns in the past few years upon researching online. If you believe that your shortlisted investments might not do as well as you expect them to do, you could consider investing in these funds. Bear in mind that there is no guarantee of these funds repeating their performance from the recent past.
• Inculcate investing discipline and follow your plan: Investing in small cap fund requires you to adopt a disciplined investment approach. If you have formulated an investment plan based on your risk appetite and investment objective, you should stick to that plan regardless of the volatility of market conditions. You should assess your small-cap funds regularly to check if any reorganisation is required.

• Invest through SIPs: Investing through systematic investment plans (SIP) can help you inculcate the investment discipline mentioned in the previous point. SIP protects your small-cap portfolio from all forms of volatility.

• Diversify your portfolio: You must prioritise the diversification of your portfolio. Assessing and re-assessing your portfolio from time to time is a very important skill. You must continuously diversify your small-cap fund portfolio to minimise risk.

• Assess your risk appetite and invest accordingly: Just as the nature of your investment goals changes, your risk appetite, too, changes over time. You must, therefore, continuously assess your risk-taking capacity and accordingly decide whether you wish to make changes to your small-cap fund portfolio.

You must note down your investment objectives and thoroughly assess your risk-taking capacity before investing in a small-cap fund.