The term "small cap" funds are used to classify companies which have small market capitalization.
What is market capitalization?
It is the company’s market value of the outstanding shares. A small cap company generally lies between $300 million and $2 billion.
To calculate market capitalization below is the formula.
Market capitalization = Current Share Price * No. of outstanding shares
Small Cap companies generally provide more room for growth to the investors. The risk factor is greater than large cap companies. But, small cap funds have outperformed large cap funds. The performance is based on the economic climate as well. During the tech bubble of the 1990s, large cap companies dominated the market. But in March 2000, after the bubble burst, small cap companies became better performers.
The scores of small cap funds have become big now giving investors a return of 30-50%. This return is seen over a period of 10-15 years. A typical small cap fund invests over 50% money in stocks of small companies. But, the fund manager can lower the expenditure depending on the market conditions.
Let us take an example to understand how small cap funds work.
A small grocery store can blend its products as per the customer needs quicker than big companies. Although the small companies may not have the same price influence as larger companies they can tailor their products to the needs of the customers. Hence, when you are investing in small-cap funds, it is like investing in 100 successful corner stores than investing in 1 large firm.
In addition, when fund managers invest in small cap companies they work hard to ensure that they are financially sound and have healthy management teams.
Risks involved when investing in Small-Cap Funds
To build a perfect portfolio of small-cap funds, it is a challenge for the fund manager. As the listed companies on the stock exchange are huge and many are not well-known. Many times the companies have to rely on the primary research.
Another risk factor is the low volumes which make stocks illiquid. Hence, the investor cannot sell the stocks as and when they want. Thus, the small cap funds are prone to liquidity risk.
Small cap companies see sudden rise and fall in stock prices. This affects the Net Asset Value of the funds investing in stocks. Hence, such companies are prone to volatility. Hence, investors with big appetite should invest in small cap funds.
Things to consider before investing in small cap funds
If you have a huge investment horizon, only then it is recommended that you plan to invest in small cap funds. Small cap funds suffer the steepest fall in the bear market and the steepest rise in the bullish market. One should have the patience of 3-5 years to allow the fund to gain from at least one complete run.
A small cap fund also witnesses frequent changes in the market. Small-cap funds are good for a small part of the portfolio. There are many companies in the small cap funds which can become success stories of the future.
How to choose small-cap funds that offer good returns?
The first thing to look for is the time the promoter has been in the business and if they are backed by a strong team. The retail investors generally do not have any option but to rely on the research reports.
A high promoter’s stake shows his confidence in the company. Hence, you should ask if the promoter plans to increase his stake in the company.
A unique business model goes well for the company in the long run. If the small cap company is present in the place with deep pockets, it is likely it will close up sooner or later.
Experts suggest that institutions avoid buying small cap funds due to lack of liquidity. But if you come across one, you should consider that stock seriously.
So decide which kind of mutual fund suits you the best and go ahead, invest!