Factors to consider before investing in small-cap funds | Value Research Advantages and disadvantages of investing in small-cap funds
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Four reasons to invest in small-cap funds

There are certain factors to consider before investing in small-cap funds

Are small-cap funds good for long-term investment (retirement)? - Varshil Gupta

Having a long-term horizon isn't the only factor to consider while investing in small-cap funds. You should also be able to withstand losses or decline in the value or inertia of the fund.

In the long term, you should consider small-cap funds for wealth creation. However, investing in a small-cap fund is not easy. They are prone to continuous free falls. You will be anxious when you are putting your money in something that is not earning returns when other parts of the markets are doing well. That is why you should not allocate more than 10-15 per cent of the overall corpus to small-cap funds.

On the other hand, there are hundreds of examples where you pick a small company and it turns big. That is a phenomenal thing. It actually creates wealth. The peril is that for every such company (e.g., HDFC Bank), there could be another which destroys your wealth. Small companies are more vulnerable as they lack the robustness and the ability to withstand cyclicality.

Advantages:

  • High growth potential: They are wealth generators in the long run. They also provide growth when large-cap stocks don't perform.
  • Untapped market: They are underfollowed in the stock market and are usually untapped by institutional investors, giving a huge opportunity to wise investors to grow their investments.
  • Diversity of options: As the small-cap universe is large, every small-cap fund is different. They have a different emphasis and a different portfolio. There is hardly a commonality in their portfolio and hence, they don't look alike.
  • Average out risks and costs: SIPs can help average your investments, reducing your risk substantially. Diversification across companies is very good because for small companies, you don't have plenty of information to decode and understand.

Disadvantages

  • Liquidity: It is a major challenge for small-cap funds. It is tough to be able to find small-cap stocks in the numbers and volumes that funds require. Also, selling them quickly might drop the stock price due to a liquidity crunch.
  • Big is not good: Contrary to large-cap funds, small-cap funds are good when AUM is small (such as Rs 2,000 crore or less).
  • High volatility: Small-cap stocks are riskier compared to the mid-caps and the large-caps and their price movements can be quite volatile. Most companies are unable to withstand the down cycles or the changing market dynamics.
  • Timing can impact returns: Time of entry and exit can deviate your returns (vs fund returns) greatly as they tend to be very volatile.

Suggested watch: Is it better to invest in mid-caps than small-caps?

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