3 Reasons to Avoid Small Cap Funds

Small-cap funds are equity funds focusing on investing in small companies in India. These companies typically have a market capitalisation of less than Rs. 5,000 crores. These companies are generally outside the top 250. They are often not well-known in our everyday lives. Small-cap funds can yield high returns but are also known for their high volatility. This is because of factors like volatility, low liquidity, and shorter track records, which we will discuss further in this blog.

How to Invest in Small-Cap Funds

1. Systematic Investment Plan (SIP) or Systematic Transfer Plan (STP):

Investors can choose SIPs or STPs. These involve investing fixed amounts often, monthly or quarterly, into small-cap funds. SIPs allow for disciplined investing. They help to spread the cost of buying units over time and can reduce the impact of market volatility.

2. Long-Term Investment Horizon:

Small-cap funds are generally suitable for investors with a long-term investment horizon. Investors may ride out market ups and downs by staying invested for a long time. They may also benefit from the growth of smaller companies. This fits the fluctuations of small-cap investments. They are unpredictable and volatile, which allows investors to get higher returns over time. Investors must do thorough research to assess their risk tolerance and consider consulting a financial advisor before investing in small-cap funds or any other investment.

Disadvantages of Small Cap Funds

While small-cap funds offer growth potential, investors should be aware of their drawbacks as well : 

1. Risky and Volatile

The inherent risk and volatility associated with small-cap funds cannot be overstated. These firms are often hit harder by market swings and economic downturns. Since these companies are small, even small market or industry changes can significantly affect their stock prices. This leads to big swings in small-cap fund values.

Larger companies have diverse revenue and strong finances; unlike them, small firms often need more cushion to handle such risks. This makes their stock prices more volatile. Investors require a superior strategy for managing risk. They must also understand the potential for considerable swings in their investment's value. Engaging with small-cap funds requires active risk management.

2. Not suited for all investors

Investing in small-cap funds requires a specific kind of investor. Since these funds are riskier, they must be comfortable with big swings and the chance of loss. Small-cap companies are more sensitive to markets and the economy. People with low-risk tolerance may find small-cap funds to be a bad investment. The same is true for those seeking immediate or consistent returns.

Investors need to be both risk-tolerant and patient during long market swings. Before investing in small-cap funds, one should have a strategy and a long-term view. For investors who don't fit these requirements, other investments might be better for them to meet their needs.

3. Liquidity Challenges

Small companies often need help with liquidity. This is because few shares are bought and sold. It is hard to trade them quickly without affecting the stock price. This can cause problems for investors trying to buy or sell shares without making the price go up or down. Less trading widens the gap between buyers' pay and sellers' wants. This makes it more costly for investors to trade. Also, large investors might avoid these companies because of the low trading. So, people investing in small company stocks or funds must be careful. Low liquidity can make prices swing a lot and make it challenging to buy or sell shares at the price they want.

Reasons to Not Invest in Small Cap Funds

Here are some reasons that should not be the basis for investing in small-cap mutual funds:

1. Guidance from acquaintances:

Small-cap funds have gained popularity, evidenced by the recent surge in investments. Chances are, someone in your circle is already investing in them. However, following others' choices blindly may not suit your unique financial goals. Each investor's needs vary, so it's essential not to rely solely on recommendations from peers when making investment decisions.

2. Market highs influencing investments:

When stock markets hit record highs, investors often rush to join the upward trend, especially in small-cap funds that offer substantial returns. However, market movements are tricky, and small-cap funds are inherently volatile. Your investment decisions should not be based on market fluctuations but on your financial situation, objectives, and risk tolerance capacity.

3. Temptation of high returns:

The tempting factor driving investors' decisions is the returns generated by existing funds. Those who review the recent performance of small-cap funds will notice a significant increase of 7 small-cap companies over the past three years and the preceding year. However, according to a recent report, 15 small-cap funds still need to beat their benchmarks out of 22 small-cap schemes in the market for the last three years.

The following table showcases the Small Cap Funds Underperformers in the Past Three Years. 

Conclusion

In short, it's essential to be careful when investing in small-cap funds. Trusting only your friends' advice, following market trends, or getting high returns can be risky, especially since small-cap funds might only suit some. Instead, do thorough research, consult a financial expert.