Small cap mutual funds are equity schemes that primarily invest in companies ranked 251st and beyond in terms of market capitalization, as defined by SEBI. These companies are often in their growth phase and have the potential to deliver significant long term returns. However, they also come with higher volatility and risk compared to large cap or mid cap counterparts.
If you are building or reviewing your mutual fund portfolio, you might wonder whether small cap funds deserve a place in it. This guide aims to help you make an informed decision by explaining the small cap universe, the reasons behind their outperformance or underperformance, insights into Kotak Smallcap Fund’s strategy, and whether a SIP in small cap funds is suitable for your financial goals and risk appetite.
Key Takeaways
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Small cap mutual funds invest in companies ranked 251st and beyond by market capitalisation as per SEBI guidelines.
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These funds offer high growth potential but come with higher volatility and liquidity risks.
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A Systematic Investment Plan (SIP) in small cap funds helps manage market fluctuations and builds wealth over time.
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The Kotak Smallcap Fund follows a research driven, bottom up approach with a focus on under researched businesses.
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Ensure diversification in mutual funds by combining small cap exposure with large cap, mid cap, hybrid, and multi asset funds.
Defining the Small Cap Universe
As per SEBI’s guidelines, small cap stocks refer to all listed companies that are ranked 251st and onwards based on their full market capitalisation. These companies are usually in the early stages of their business cycle ranging from emerging enterprises to niche businesses with scalable potential.
Mutual fund schemes categorised as small cap funds are required to invest a minimum of 65% of their total assets in such small cap companies. This focused exposure can offer long term growth opportunities, but it also introduces higher volatility. Since many of these companies receive limited institutional or analyst attention, experienced fund managers often rely on bottom up research and active stock picking to identify potential outperformers and create alpha over the benchmark.
Why Small Caps Can Outperform (and Underperform)
Small cap stocks often display a wide range of performance outcomes, driven by their growth stage, business scalability, and market sentiment. This segment can deliver strong returns but not without elevated risks.
Potential Advantages:
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High growth potential: Many small cap companies are in early expansion phases, with the possibility of significant earnings growth over time.
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Market inefficiencies: Limited institutional coverage can lead to undervalued opportunities that skilled fund managers can uncover.
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Cyclical tailwinds: Small caps often benefit more during periods of economic recovery or bullish market cycles due to their agility.
Associated Risks:
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Greater volatility: These stocks tend to be more sensitive to market movements and economic changes.
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Liquidity concerns: Smaller trading volumes may lead to higher impact costs, especially during turbulent market phases.
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Drawdowns in downturns: In broad market corrections, small caps typically witness steeper declines compared to large cap stocks.
Inside Kotak Smallcap Fund: Strategy in Practice
The Kotak Smallcap Fund is one of the well regarded schemes in the small cap space. The fund follows a bottom up stock picking approach, focusing on fundamentally strong businesses with scalable models and sustainable competitive advantages.
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Targets under researched small cap companies with hidden growth potential
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Bottom up stock picking approach focused on company fundamentals
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Diversified portfolio to reduce stock specific risk
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Backed by in house research and long term conviction
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Aims to generate risk adjusted returns through disciplined investing
Who Should Consider a Small Cap SIP
A Systematic Investment Plan (SIP in mutual funds) can help you benefit from small cap growth while managing market volatility.
You may consider a small cap SIP if:
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You invest for the long term and can stay invested through market cycles
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You are comfortable with short term fluctuations
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You have already built a core portfolio with large and mid cap funds
Using a step up SIP guide, you can gradually increase your investments as your income grows boosting long term returns through the power of compounding.
Diversifying Small Cap Exposure Within a Broader Portfolio
Small cap funds can play a valuable role in your mutual fund portfolio, but they are best used as a complement, not the core.
Why include them
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They offer exposure to high growth potential companies often missed by larger funds
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Useful for capturing opportunities in emerging sectors
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Can help improve overall returns through alpha generation
However, small cap funds also bring higher volatility. That is why it is important to maintain diversification in mutual funds by combining them with:
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Large cap and mid cap funds for stability
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Hybrid or multi asset allocation funds for balance
A well diversified portfolio helps manage risk and supports long term wealth creation, even during market fluctuations.
Conclusion
Small cap funds can add meaningful value to your mutual fund portfolio when approached with the right expectations and time horizon. Their potential to outperform comes with the trade off of higher risk, making them suitable for investors with a long term view and the ability to withstand short term volatility. A disciplined SIP strategy especially one that grows with your income can help smooth out the investing experience.
However, it is equally important to maintain a balanced and diversified portfolio. Small cap funds should complement, not dominate, your equity allocation. By pairing them with more stable asset classes, you can aim for long term capital appreciation while managing downside risk effectively.
FAQ
Q1. Who should invest in small cap funds
Investors with long term goals and high risk tolerance can consider small cap funds for potential growth.
Q2. Is SIP a good way to invest in small cap funds
Yes, SIP helps average out volatility and builds discipline in small cap investing.
Q3. Are small cap funds very risky
They carry higher short term risk but can reward patient investors over time.
Q4. Can small cap funds improve portfolio returns
They may boost portfolio alpha when used as a diversified satellite allocation.
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