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If you’re chasing high returns and are ready for a bumpy ride along the way, then small-cap funds could add firepower to your portfolio. These funds invest in emerging businesses that have the potential to become tomorrow’s mid-cap or large-cap giants.
But small-cap funds come with a catch: their returns can swing sharply—both up and down. That’s why they work best if you have patience, discipline and a long-term view.
In this guide, we’ll break down what small-cap funds are, how they work, their pros and cons and where they might fit in your portfolio.
What is a small-cap fund?
A small-cap fund is an equity mutual fund that invests at least 65 per cent of its assets in companies ranked 251st and below by market capitalisation, as per SEBI rules.
These companies are typically younger, faster-growing businesses. Many may be leaders in niche industries or future challengers to bigger firms, but they’re also more vulnerable to market ups and downs.
Examples of small-cap names: Granules India, Graphite India, Safari, JK Tyres are some small-cap stocks that grew significantly over time.
How do small-cap funds work?
Your money joins a pool that the fund manager uses to build a portfolio of smaller, emerging companies.
The fund manager’s job is to identify promising businesses, track them closely and adjust holdings as markets and company prospects change. Small-cap funds, unlike large-cap funds, require a closer look, as small-cap stocks are less researched and more sensitive to market conditions.
Small-cap funds’ performance: Active vs passive
After two stellar years, small-cap funds ran into rough weather last year. The BSE 250 Smallcap index corrected 21.3 per cent from September 2024 to February 28, 2025. But that didn’t deter passive small-cap funds from being popular, with index-tracking funds now accounting for around 35 per cent of small-cap fund assets.
However, all of the 28 active small-cap funds, with a relevant history, beat their benchmarks with lower declines during the downturn. Small caps are a space where active management truly shows its strength. While large-cap index funds can hold their own, small-cap investing is a different game—it means navigating through a maze of weak, unproven or overhyped companies. This is where skilled fund managers step in, steering clear of low-quality names and spotting real growth opportunities. The outperformance of active funds in the latest correction highlights how active strategies can add real value in the high-risk world of small caps, particularly when volatility hits.
Why consider small-cap funds?
- Potential for high growth: Small-cap funds aim to tap into the early growth phase of companies, offering the chance for higher long-term returns than large-or mid-cap funds.
- Build wealth over time: If you stay invested for the long haul, small-cap funds can significantly boost your portfolio’s growth. Several top-performing small-cap funds have delivered 21-25 per cent SIP returns over the last 10 years, though returns can vary widely across funds and timeframes.
Where do small-cap funds fit in your portfolio?
Small-cap funds suit you if:
- You want to target higher returns and are comfortable with sharp ups and downs
- You can stay invested for 8–10 years or longer
- You’re using SIPs to average out your cost over market cycles
They work well as a satellite holding—a small but high-growth piece of a diversified equity portfolio.
Small-cap funds’ taxation
Small-cap funds are taxed like any other equity fund:
-
Short-term capital gains tax: If a fund is held for less than a year, the tax on the gains is 20 per cent.
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Long-term capital gains tax: If a fund is held for over a year, the tax rate is 12.5 per cent for gains beyond Rs 1.25 lakh per annum. This means any gains up to Rs 1.25 lakh for the financial year are tax-free.
Things to keep in mind
- High volatility: Small-cap funds can see large swings in returns — both gains and losses — over short periods.
- Liquidity risk: Smaller company stocks can be harder to sell during market stress, which can add to the risk in down markets.
- Patience required: Small-cap funds can underperform for stretches. They reward those who stay invested through full market cycles.
Small-cap vs mid-cap vs large-cap funds
| Feature | Large-cap | Mid-cap | Small-cap |
| Growth potential | Moderate | High | High |
| Risk level | Lower | High | High |
| Ideal holding period | 5+ years | 7+ years | 7+ years |
| Who it suits | Conservative investors | Growth-seekers | Aggressive long-term investors |
Top 5 small-cap funds
| Fund name | 10Y SIP returns | AUM | Expense ratio |
|---|---|---|---|
| Nippon India Small Cap Fund | 25.01% | Rs 63,007 crore | 0.65% |
| Axis Small Cap Fund | 22.88% | Rs 25,062 crore | 0.55% |
| HSBC Small Cap Fund | 22.05% | Rs 16,061 crore | 0.63% |
| HDFC Small Cap Fund | 21.83% | Rs 34,032 crore | 0.73% |
| Kotak Small Cap Fund | 21.74% | Rs 17,329 crore | 0.55% |
FAQs on small-cap funds
Are small-cap funds risky?
Yes. Small-cap funds are the most volatile among equity funds. They can deliver high returns over time but also experience sharp ups and downs.
Can small-cap funds beat large-cap funds?
Over long periods, small-cap funds can outperform large-cap funds, but they come with much higher risk. Staying invested for the long term is key.
What is the ideal holding period for small-cap funds?
Aim for seven years or more. Small-cap funds need time to ride out market cycles and realise their growth potential.
Is SIP a good way to invest in small-cap funds?
Yes. SIPs help smooth out market volatility and reduce the risk of investing at the wrong time.
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This article was originally published on June 30, 2025.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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