5 Risks You Must Know Before Investing in Small Cap Mutual Funds

Investors in India have shown increasing interest in small cap mutual funds in recent years. These funds invest in companies ranked below the top 250 in terms of market capitalisation, according to industry classification. The attraction often lies in their growth potential, as small companies may expand faster than their larger counterparts. However, these funds also carry higher risks, which must be carefully understood before investing.

In this article, we will explore five key risks associated with small cap mutual funds. Understanding these aspects can help you make informed choices and align them with your financial goals.

Market volatility risk

A small cap mutual fund is highly sensitive to changes in market conditions. Smaller companies are usually more impacted by factors such as economic slowdown, policy changes, or global events. This makes their share prices more volatile compared to large-cap or even mid-cap companies.

For instance, during a downturn, small-cap stocks may experience sharper declines. This can affect the net asset value (NAV) of the fund in the short term. While this volatility may also create growth potential when markets recover, investors must be prepared for fluctuations along the way.

Liquidity risk

Liquidity refers to how quickly an investment can be converted into cash without affecting its price. Small-cap stocks often have lower trading volumes compared to larger companies. As a result, fund managers may find it difficult to buy or sell these stocks quickly in large quantities.

This lower liquidity can sometimes cause price distortions and make the fund more vulnerable during stressed market phases. For investors, this translates into the possibility of sharper NAV movements during times of heavy buying or selling pressure. A long-term investment horizon may help manage this challenge, but the risk remains inherent in the small-cap category.

Concentration risk

Many small-cap companies are niche players operating in specific industries or markets. While this may allow them to grow quickly in favourable conditions, it also exposes them to risks if their sector faces challenges. A small cap mutual fund with higher concentration in a few such companies may see increased volatility.

For example, if the fund has a significant allocation to a particular industry and that industry faces regulatory or demand-related challenges, the overall portfolio could be impacted. Diversification within the fund may help reduce concentration risk, but it cannot eliminate it entirely. Investors must recognise that such risks are part of the structure of small cap funds.

Limited information risk

Compared to large companies, small-cap firms may have limited analyst coverage, lower levels of public disclosure, or shorter track records. This means there may be fewer reliable data points available for assessing their performance and long-term prospects.

Fund managers rely on in-depth research to identify such companies, but the availability of less information can make the process more complex. For investors, this adds another layer of uncertainty, as the valuations of such companies may be harder to predict. It is important to acknowledge this limitation when considering an investment in a small cap mutual fund.

Longer holding period requirement

Small-cap stocks usually take longer to realise their growth potential. Their business models may require more time to stabilise, expand, and generate consistent profitability. As a result, small cap mutual funds are generally more suited for investors with a long-term horizon.

Investors who may need their money in the short term could find these funds unsuitable, as short-term market movements may dominate potential returns. For instance, an investor who withdraws within two years might face volatility that reduces potential gains. Therefore, a holding period of at least five to seven years is usually considered more appropriate to balance out these risks.

Using an SIP calculator for planning

One way to manage the volatility associated with small cap mutual funds is through a systematic investment plan (SIP). An SIP allows you to invest a fixed amount at regular intervals, thereby spreading your investments across different market conditions. This may reduce the impact of short-term volatility and help average out purchase costs over time.

You can use an SIP calculator to estimate potential outcomes based on different investment amounts and time horizons. These tools can help you set realistic expectations and plan for the long term. Keep in mind, though, that the calculations shared by these calculators are not guaranteed, but just projections.

Conclusion

A small cap mutual fund can be an option for investors who are comfortable with higher risk and are willing to stay invested for the long term. While the growth potential of small companies may appear attractive, it is equally important to be aware of the risks discussed above, including volatility, liquidity challenges, concentration, limited information, and the need for a longer holding period.

Before deciding to invest, it is advisable to assess your risk profile, investment horizon, and financial goals. Investors should also consider consulting with a qualified financial planner or investment advisor to determine whether small cap funds fit into their overall portfolio strategy.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.