How Do Small-Cap Funds Work?

Investing in mutual funds involves choosing from different categories, each designed for specific investment goals and levels of risk tolerance. Among these, small-cap funds stand out for their focus on companies that are relatively small in size but have the potential to grow rapidly. These companies are often in early development phases, niche-focused, or operating in emerging industries. In this article, we will break down what small-cap funds are, how they work, their benefits, and key factors to consider before investing.

What Are Small-Cap Funds?

Small-cap funds are mutual funds that primarily invest in the stocks of companies with relatively smaller market capitalisation, typically ranked below the largest firms in the market. According to SEBI guidelines, at least 65% of a small-cap fund’s portfolio must be allocated to small-cap stocks.

These type of fund invest in businesses that are still in their growth phase. If these companies succeed in scaling up, the returns can be substantial. However, with this growth potential comes higher volatility and risk, since smaller companies are more vulnerable to market and economic shifts.

How Small-Cap Funds Work

A small cap fund follows a structured investment process that combines research, active management, and patience:

Pooling Investments: The fund collects contributions from multiple investors, creating a large pool of capital. This allows the fund to invest across many companies and sectors.
Selective Stock Picking: Fund managers conduct detailed research to identify potential businesses. They evaluate factors such as leadership quality, competitive advantage, financial strength, and future growth potential.
Portfolio Management: Once stocks are selected, they are actively monitored. If a company outgrows the small-cap category or no longer meets the fund’s criteria, it may be replaced.
Growth-Focused Holding Strategy: Many small-cap companies take years to realise their potential. Fund managers often hold these investments for the long term to benefit from the entire growth phase.

Benefits of Small-Cap Funds

While small-cap funds involve higher risk, they also offer several advantages:

High Growth Potential – Small companies have more room to expand compared to large corporations, which can result in significant capital appreciation over time.
Early-Stage Opportunities – Investing early in a company’s growth phase can lead to significant gains if the business scales successfully.
Diversification Advantage – Small-cap funds invest across multiple sectors and companies, reducing the risk of being dependent on a single stock.
Market Inefficiency Gains – Smaller companies are often overlooked by large institutional investors, giving skilled fund managers a chance to find undervalued opportunities.
Potential to Beat Inflation – Over the long run, well-performing small-cap funds have historically outpaced inflation, helping preserve and grow purchasing power.

Who Should Consider Investing?

Small-cap funds are ideal for investors with a high-risk appetite and long-term goals, willing to manage market volatility. Small-cap funds focus on smaller companies with high growth potential but greater vulnerability to market swings.

You may consider investing in small-cap funds if:

You can commit your funds for 7–10 years or more to allow these companies time to grow.
You are comfortable with short-term volatility in exchange for potentially higher long-term returns.
You already have a diversified portfolio with stable investments like large-cap equity, debt funds, or index funds, and want to add small caps for growth potential.
You have liquidity from other sources, since small-cap stocks are less traded and may be difficult to sell quickly without affecting prices.

Factors to Consider Before Investing in Small-cap Funds

Before investing in small-cap funds:

Assess your risk appetite carefully. These funds can see sharper ups and downs compared to large-cap funds, so you should be mentally prepared for fluctuations.
Maintain a long investment timeframe, ideally 7–10 years, to ride out short-term market volatility and give small companies time to grow.
Use them as part of a diversified portfolio along with more stable investments like large caps, debt funds, or index funds to balance risk.
Monitor performance periodically, such as once or twice a year, to ensure the fund is aligned with your goals. Avoid reacting to every small market movement.
Be aware of liquidity risks. Small-cap stocks are less traded than large-cap ones, so during volatile market, prices may fall quickly. Investor seeking high liquidity often consider liquid funds app to explore convenient, low-risk, and flexible short-term investment options to keep their funds accessible.
Select funds with a consistent track record, experienced fund managers, and a disciplined investment process.

Conclusion

Small cap funds operate by pooling investor capital and investing it primarily in small, high-potential companies. These funds offer the chance to benefit from early-stage growth, but they come with increased volatility and risk. For investors with a long-term perspective and a balanced approach to risk, small-cap funds can provide significant growth potential to their portfolio. Platforms like Axis MF make investing in small cap schemes seamless and transparent, helping investors explore, compare, and monitor small cap opportunities within a trusted framework.

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Adam Regan

Deputy Editor

Features and account management. 3 years media experience. Previously covered features for online and print editions.

Email Adam@MarkMeets.com