A mutual fund investment opens up a whole new world of possibilities for investors. Whether you want to build your long-term retirement portfolio or explore short-term investments, mutual funds help you diversify your assets and get exposure to different investment strategies. When investing in mutual funds, it is common to focus on large, well-established companies for stability, however, it is important not to overlook the potential of small-cap funds.

By investing in smaller, growing companies with a market capitalization of Rs 5,000 crore or less, small-cap funds also offer exciting investment opportunities that can potentially yield high returns. But with high growth potential, they can be more volatile and come with increased risk. So, should you take the risk and invest in small cap funds? Let’s evaluate its advantages and disadvantages and find out.

Benefits of investing in small cap funds

High returns than large cap and mid cap funds

Since small-cap stocks tend to be more volatile, they can appreciate much faster when conditions are favourable and depreciate just as quickly when conditions are not. That means that if you choose your investments carefully, there’s a good chance you could see significant returns from your small cap mutual fund investments over time.

Potential for innovation and growth

Small-cap funds provide access to innovative companies, new industries, products, or services that may not yet be widely known but have potential for significant growth over time. This gives investors a chance to get involved early on with these companies before they become well-established and widely held by other investors.

Diversify your portfolio

Investing in small cap fund schemes gives investors an easy way to diversify their portfolios across emerging markets without having to invest directly in individual securities, which could be risky if not researched thoroughly. By investing in a fund that involves multiple small-cap businesses from different sectors, industries, and markets, you can reduce your risks while still having access to potentially lucrative opportunities for growth and returns.

Lower valuations

Since most small-cap stocks lack a significant track record or established brand name, they tend not to be valued as highly as large-cap stocks. It means there is a possibility of finding undervalued stocks at a discounted rate which could lead to higher returns over time.

Risks associated with small cap fund investments          

Volatility

Small cap funds experience more volatility than large-cap and mid cap funds. These stocks can be particularly sensitive to economic and market conditions, which can make their valuations more unstable. As a result, these mutual fund schemes are susceptible to greater market fluctuations and, thus, must be carefully analysed and researched.

Liquidity risk

Small cap funds are subject to liquidity risks which can occur when trading volume is low, and there are few buyers or sellers willing (or able) to trade at any given time

Less dividends

Small cap funds tend not to pay dividends as much as large-cap stocks do. This means that although you may get higher returns from investing in these stocks, you may also miss out on some income from dividends paid by large-cap companies. That said, if you believe in the long-term potential of a company’s stock price, then this drawback may be worth it for you.

So, who should invest in small cap funds?

Despite common misconceptions, small cap funds are not just for high-risk investors. Their exponential growth potential, exposure to different emerging sectors, and professional management make them a valuable addition to any investment portfolio. Therefore, with the right research, market analysis, portfolio management, and professional guidance, small-cap funds can help you unlock long-term potential returns and meet your different financial goals.