8 best small cap mutual funds to invest in 2024

Historically, small-cap funds have demonstrated superior performance compared to other equity categories over extended periods, presenting the prospect of generating alpha, i.e., excess returns beyond the benchmark. Nonetheless, these funds generally allocate investments to a smaller pool of companies, elevating the concentration risk and the possibility of losses if a subset of companies underperforms. 

Additionally, small-cap stocks exhibit heightened sensitivity to market fluctuations, resulting in more pronounced price volatility, both on the upside and downside, compared to their large-cap counterparts. This phenomenon explains the extreme highs and lows observed in funds that invest in these stocks.

To identify small-cap funds that have maintained consistent performance over the last decade or more, it’s essential to first grasp the nature of these funds and recognize their potential contribution to an investment portfolio.

What are small-cap funds?

Small-cap funds are mutual funds with an equity focus, obligated to allocate a minimum of 65 per cent of their assets to equity and equity-related instruments of small-cap companies. They possess the flexibility to invest the remaining 35 per cent in stocks of large-cap or mid-cap companies, debt instruments, or cash and equivalents.

These funds have the potential to recognize and invest in undervalued companies, paving the way for substantial growth when their full potential is realized. The adaptability in investing across small-cap stocks and other options empowers fund managers to customize the fund’s risk-return profile in alignment with their specific investment objectives.

Assessing funds’ performance in the small-cap space

Over an extended period, small-cap funds have demonstrated superior performance compared to other equity categories, including large-cap and mid-cap funds. This notable outperformance is attributed, in part, to the elevated growth potential inherent in small-cap companies.

Evaluating the returns of small-cap funds over the last decade is a method for assessing their performance, although seasoned investors consider various factors such as the portfolio turnover ratio, expense ratio, and fund management, among others, to determine whether the fund would be a beneficial addition to their investment portfolios.

Risks inherent in small-cap investment

Investing in small-cap stocks entails greater risks compared to large-caps. Nevertheless, opting for mutual funds focused on small-cap investments can mitigate certain inherent risks associated with this category of investing. One can benefit by investing in the small-cap space owing to

Minimized volatility: The fund achieves reduced fluctuations by diversifying across numerous small-cap companies, thereby mitigating the impact of individual stocks’ ups and downs. Consequently, the overall value of your investment is less susceptible to abrupt declines resulting from the underperformance of one or two companies.

Expert oversight: Fund managers, possessing specialized skills in researching and analysing small-cap companies, excel in identifying promising entities with robust growth potential and steering clear of those exhibiting warning signs. This diminishes the likelihood of you selecting an underperforming investment.

Ease of trading: Due to their low trading volume, buying and selling small-cap stocks can be challenging. Nevertheless, mutual fund units usually offer high liquidity, enabling you to readily redeem them as necessary.

Reduced expense ratios: Although mutual funds involve fees, they are typically lower compared to the commissions incurred when trading individual small-cap stocks.

Nevertheless, allocating funds to small-cap funds doesn’t completely insulate investors from the market risks associated with investing in individual small-cap stocks. It’s crucial to acknowledge that small-cap mutual funds still entail certain risks. 

Small-cap funds are most appropriate for investors with a high tolerance for risk and a long-term investment horizon. Those considering these funds should be ready to withstand short-term volatility in pursuit of the potential for greater long-term returns. While small-cap funds can be a valuable asset for investors seeking higher returns at the expense of increased risk, it is crucial to thoughtfully assess your risk tolerance and investment objectives before committing to these funds.

In general, small-cap mutual funds present a more well-rounded approach to investing in small-cap companies compared to independent efforts. They can assist in alleviating certain risks while retaining the potential for increased returns. Nonetheless, it is essential to thoroughly research the particular fund, comprehend its fees, and contemplate your overall investment strategy before committing.

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Published: 07 Dec 2023, 10:02 AM IST