There are a number of equity fund categories, such as the large, mid and small-cap funds, each offering its own benefits and disadvantages. Small-cap funds tend to have the highest upside due to the growth potential of the stocks within their portfolio, however, these also come with increased risk.
A small-cap equity fund is essentially named after the category that the stocks in this fund basket belong to in terms of market cap. Generally, a small-cap equity company is considered to be one that has a market capitalization of 5,000 crores or under. A small-cap fund, therefore, is one that invests in these companies.
As with all fund categories and investments in general, it is not as simple as ‘yes’ or ‘no’ as small-cap funds, much like all other funds, have their own pros and cons. However, by understanding these pros and cons, we can aim to understand how we can maximize our returns from small-cap funds.
One of the most apparent downsides of a small-cap fund is the risk that you take on. Since companies are in their infancy, they are yet to prove themselves to be credible, and can often make risky moves to establish themselves or get ahead, which could cost you as an investor. Additionally, since small-cap funds have higher risk, the fund manager has to make more trades to switch stocks and out to maximize returns, which could result in higher transaction fees.
It is often recommended that if you are not a skilled investor, you should begin your investing journey with large or mid-cap funds and stocks, as they allow for a more moderate risk appetite, which will offset the lack of experience one has. Over time, however, one will notice the higher rewards that are possible with a small-cap fund, though it is essential to continue to acknowledge the risks.
While a small-cap fund is risky, the high risk also provides the opportunity for high rewards. Fund managers who are managing small-cap funds will generally have a more aggressive investment strategy, as they are relying on the company’s rapid growth for returns, not its stability (for which they would give us large-cap stocks). As a result of this, if the fund manager is skilled, they will be able to pick the right stocks and extract maximum returns from the small-cap fund.
small-cap funds are a good addition to your portfolio if you are looking for aggressive investments, have a high-risk appetite and are chasing higher rewards as a result. On the downside, however, these funds also pose a higher risk, meaning there is a risk of your risk not paying off, landing you in the red. As always, the best approach is to diversify your portfolio, investing in small, mid and large-cap funds, in addition to other financial instruments.
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