What Are Small-Cap Funds? Risks, Returns, and Should You Invest?

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

1. High Growth Potential – Small companies can grow faster than established ones, creating opportunities for outsized returns.

2. Early-Stage Exposure – Investors get to participate in businesses before they scale into mid or large caps.

3. Diversification – Adds exposure to segments of the market often missed by large-cap funds.

4. Long-Term Wealth Creation – Over long horizons, disciplined small-cap investors have historically seen strong compounded growth.

Disadvantages of Small-Cap Funds

1. High Volatility – Prices swing sharply in both directions, often more than the broader market.

2. Liquidity Risks – Smaller stocks may be harder to buy or sell in tough times.

3. Slow Recovery – After corrections, small caps often take years to bounce back.

4. 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.

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.