What Are Small-Cap Funds? Risks, Returns, and Should You Invest?
- Small-cap funds invest in companies ranked 251st and below by market capitalization.
- They offer strong long-term growth potential but also carry sharp volatility and higher risks.
- Best suited for younger investors with long horizons and high risk tolerance.
- SIPs and discipline are essential to manage volatility in small-cap funds.
Small-cap funds are known for their ability to deliver extraordinary returns over time. But with high growth potential comes equally high risk. Here’s a clear look at how they work, their pros and cons, and whether you should invest in them.
What Are Small-Cap Funds?
In India, the Securities and Exchange Board of India (SEBI) defines small-cap funds as mutual fund schemes that invest primarily in companies ranked 251st and below by market capitalization.
These are smaller, emerging businesses that may operate in niche industries or be at early growth stages. Because of this, they can expand rapidly when conditions are favorable, but they are also more vulnerable to downturns, liquidity issues, and business challenges.
In simple terms, small-cap funds are the “high risk, high reward” corner of equity mutual funds.
How Do Small-Cap Funds Work?
When you invest in a small-cap fund, your money is pooled with other investors and allocated into a portfolio of small companies. By SEBI regulation, at least 65% of the portfolio must remain in small-cap stocks.
-
In bull markets: small caps often rally harder and outperform larger peers.
-
In bear markets: they tend to fall deeper and take longer to recover.
This cycle makes small-cap funds a rollercoaster ride one that rewards patient, long-term investors but can unsettle those with a short-term mindset.
Advantages of Small-Cap Funds
-
High Growth Potential – Small companies can grow faster than established ones, creating opportunities for outsized returns.
-
Early-Stage Exposure – Investors get to participate in businesses before they scale into mid or large caps.
-
Diversification – Adds exposure to segments of the market often missed by large-cap funds.
-
Long-Term Wealth Creation – Over long horizons, disciplined small-cap investors have historically seen strong compounded growth.
Disadvantages of Small-Cap Funds
-
High Volatility – Prices swing sharply in both directions, often more than the broader market.
-
Liquidity Risks – Smaller stocks may be harder to buy or sell in tough times.
-
Slow Recovery – After corrections, small caps often take years to bounce back.
-
Business Fragility – Smaller firms have fewer resources, making them more vulnerable to shocks.
Because of these drawbacks, small-cap funds aren’t suitable for conservative investors or those with short-term financial goals.
Recent Returns of Small-Cap Funds
Performance has been strong for those who stayed invested long term:
-
3-year average category return: ~27% CAGR
-
5-year average return: ~21% CAGR
-
10-year average return: ~18–19% CAGR
(Source: Value Research, April 2025 category averages)
These returns highlight why investors are attracted to small caps. But they also reinforce a critical point: the journey is volatile, and only patient investors truly benefit.
How is Taxation on Small Cap Fund Returns Calculated?
Understanding taxation is critical before investing.
-
Short-Term Capital Gains (STCG): If units are sold within 1 year, gains are taxed at 20%.
-
Long-Term Capital Gains (LTCG): If units are sold after 1 year, gains up to ₹1.25 lakh per financial year are exempted from tax. Above this, LTCG is taxed at 12.5% (without indexation).
-
Dividends: Taxed as per your income tax slab.
These rules directly affect the Equity cap fund returns investors finally take home.
Should You Invest in Small-Cap Funds?
Small-cap funds are not for every investor. They suit specific profiles where time and risk appetite align.
Who Should Consider Small-Cap Funds?
-
Age group: Typically investors in their 20s to early 40s who have decades of earning and investing years ahead.
-
Time horizon: At least 7–10 years or longer.
-
Risk appetite: Those comfortable with seeing short-term portfolio declines of 20–30% without panicking.
-
Portfolio stage: Investors who already hold large-cap and mid-cap funds, and want to add small caps for growth potential.
Who Should Avoid Small-Cap Funds?
-
Retirees or near-retirees who prioritize stability and income.
-
Those who are not comfortable taking on market risk and prefer guaranteed returns.
-
Investors saving for near-term goals like home purchase or child’s education in the next 2–3 years.
How Much Should You Invest?
-
Aggressive investors: 10–15% of equity allocation.
-
Moderate investors: 5–8% of equity allocation.
-
Beginners or risk-averse investors: keep exposure minimal or avoid altogether.
Small-cap funds should act as a supporting piece of your portfolio, not the foundation.
FAQs
1800+ Google Reviews. A 4.7 Star Rating. Zero Sales Targets.
"It's been over 7 years I am with this firm and they have met all my investment requirements from day 1. Archana Lamba's prompt Assistance and clear guidance helped me to stay focused on my Goals. Thank you Team and Archana Lamba for your amazing support. Kudos👍👍"
Tarun Gupta
1800+ Google Reviews. A 4.7 Star Rating. Zero Sales Targets.
"I have been associated with Finedge Advisory Pvt Ltd for the past 12 years, and the experience has been truly rewarding. Under the expert guidance of Ms. Archana and the Finedge team, I have received excellent mutual fund investment advice – always free of charge and focused purely on my financial well-being. Their advice has been consistent, professional, and tailored to my goals. Over the years, the wealth created through these carefully chosen investments has enabled me to achieve significant milestones – including purchasing two houses and a car. What I deeply appreciate is their transparency, client-first approach, and long-term vision in financial planning. Finedge and Archana have been more than just advisors; they have been trusted partners in my financial journey. I highly recommend Finedge Advisory Pvt Ltd and Archana to anyone looking for reliable, ethical, and impactful investment guidance."
Shabaz Mulla
1800+ Google Reviews. A 4.7 Star Rating. Zero Sales Targets.
"It's a great platform and the executives are very well trained and trusted organisation. We can rely on the suggestion and based on our decision we can invest. From past 10 years i have been associated with Finedge it's good to be with them."
Anil Kumar
Your Investing Experts
Continue Reading
.png)
Equity Savings Funds: The Perfect Blend of Safety, Growth, and Tax Efficiency
In a market where investors want growth without volatility, Equity Savings Funds offer a disciplined middle path. They combine the growth potential of equities, the stability of debt, and the hedging benefit of arbitrage funds. For conservative investors seeking low-risk mutual funds with mutual fund tax efficiency, these schemes offer stability, discipline, and clarity core principles of FinEdge’s goal-based approach.
ULIPs vs Mutual Funds for Wealth Creation: Which is Better?
ULIPs combine insurance and investment, while mutual funds focus purely on returns. For wealth creation, separating the two is almost always better.
.png)
Balanced Advantage Funds (Dynamic Asset Allocation Funds): Meaning, Returns, and Taxation
Balanced Advantage Funds, also called Dynamic Asset Allocation Funds, dynamically manage equity and debt exposure to provide a balance of growth potential and downside protection.