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Is Investing in Small Cap Funds a Good Idea?

Market capitalization is an important financial term for commercial entities. It is the product of the share price and number of outstanding shares. There are three types of companies, distinguished based on market capitalization – small cap, mid cap and large cap.

What are small cap companies?

Small cap funds belong to companies that have smaller market cap. In India, a company that has a market capitalization below INR 5000 crores is categorized as a small cap company. Globally, small cap companies are companies that have market capitalization that lie between $300 million and $2 billion. The number of publicly traded stocks are less in the small cap companies compared to large and mid-cap companies. Most of the shares of small cap companies are held by owners, institutional and individual investors.

As the name suggests, small cap stocks usually feature lower share offerings where transactions take a bit of a longer time to finalize.

The truth about small cap funds

If you are an investor and wish to invest in small cap funds, then you need to know few facts. Three reasons why investing in small cap companies is attractive are:

  1. Typically, small cap funds are always able to perform better than large-cap funds.
  2. Historically small caps offer profitable returns vis-à-vis large caps.
  3. Small caps stocks provide investors the opportunity to grow better and faster than large caps stocks.

Are small cap investments a good option?

Consider investing in small cap funds from two perspectives:

  1. Growth

In a nutshell, small cap stocks tend to be risky investments characterized by a downswing or downward swing in the value of the stocks, after a period of good economic business activity like rising prices. This is because large-cap companies have the finances and strategies in place to weather through the economic turmoil and instability – a feature that small cap companies do not have.

However, even though most investors like to take their chance with the large-cap funds because of their low volatility, when it comes to growth potential, it is the small-cap companies that hold better promise. Small-cap companies have tremendous flexibility vis-à-vis the larger ones in changing their directions and strategies fast and quick. This is primarily because of their size – they can grasp newer opportunities more effectively and take advantage of these situations and events better. It is all because of the small size of their market cap – they can take more risks, chances and capitalize on changing trends with more nimbleness than the others. Which is why small cap funds offer higher rates of return on investment than mid-cap and big-cap companies.

  1. Performance

Take this example, in a period of about 37 years – from 1979 to 2015, small cap funds in the Russell 2000 paid almost the same annual returns to investors as large caps companies. In fact, on certain parameters, the small cap companies outperformed the large ones.

How to capitalize on small cap investments?

Since the market risks associated with small-cap funds are higher, it is advisable only for such investors who have the financial power and capacity to bear these risks, not for the present, but also for at least another 7 to 10 years. However, for others, it does not mean that they should stay away from putting their money into the small cap funds. Interested investors should:

  • Start with allocating a less-than substantial part into the small-cap funds.
  • Follow a planned strategy for investing in small cap funds.
  • Know that diversification is an important strategy that helps stretch the risks across multiple portfolios.

Following the Systematic investment plan or SIP is the ideal way to go about investing in small cap funds. Since this scheme includes deductions at regular intervals instead of engaging a lump sum amount in one-go, SIP is the right plan to approach small-cap investments. The good thing is that many small cap stocks and investments allow only SIP and not lumpsum investment.

Small cap investments work out best for investors who want to wish to achieve financial goals that are long-term. For example, investors who start young and want to make retirement-related savings, investing in small caps make for prudent decisions.

For small cap investments to work in your favour, you need to research diligently and find intricate details about small cap offerings. Keep the research as exhaustive as possible. If you really wish to make your investments in small cap stocks and you want to gain profitably, make sure that you spend time in looking out for announcements about new and latest offerings. The fact is that even today, when we have a lot of  information, the market gives more attention to offerings from large cap companies rather than the smaller ones. Even the slightest of activity by the large companies get all media coverage but new developments, innovations and acquisitions from the small cap companies are more prone to get ignored. Investors should, therefore, ensure that they are well informed before taking any kind of decision.

Word of caution

Small cap funds are more risk-prone than large-cap stocks.

Small-cap companies do not usually have the kind of financial capabilities and resources that large-cap companies have which is why they are comparatively more volatile and are more vulnerable than large-cap companies. This makes small caps risky investment, especially when market conditions are in the contraction phase; where the small cap companies are not so well-equipped as their larger cap counterparts to handle the decrease in demand. The risk factor of small cap funds gets accentuated by the fact that the actual returns are significantly different from the calculated average returns. So, if you are an investor who can stomach the ups and downs of stock values on almost a daily basis, then investing in small cap funds should be your chosen investment strategy.

Also, one important feature about small cap funds is that the investors can face a challenging time in offloading the shares because of the lower liquidity factor. So, as an investor, you may take time to buy or sell your holdings in the market.

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About the Author: Praveen Unnikrishnan

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