Small-cap stocks tend to be more volatile yet have the potential for higher returns over the long term than large-cap stocks. This makes small-cap category in mutual funds an intriguing yet risky proposition for investors. While the possibility of stellar returns is tempting, the volatility can scare away novice investors. This article aims to objectively examine the pros and cons of small-cap index mutual funds so you can make an informed investment decision.
Read on to understand what makes small-cap index funds a better option, how they work, taxation rules, and, most importantly, whether you should invest in them or not.
What are Small Cap Stocks and Index Funds?
Before examining small-cap index mutual funds, it is important to understand what constitutes small-cap stocks and what index funds are.
Small Cap Stocks:
Stocks of companies with a market capitalisation of between Rs 500 crore and Rs 2500 crore are classified as small-cap stocks according to SEBI guidelines. Being smaller in size, these companies are in the early stages of growth and have the potential to become much larger over time. However, they face volatility, given their small-scale operations.
Index Funds:
Index mutual funds are passively managed funds that attempt to replicate the performance of a market index like Nifty 50, Sensex, Nifty Next 50 etc. For example, funds that track Nifty 50 buy all the 50 stocks of the index in the same proportion as their weightage. Index funds have low costs due to passive investing and avoid fund manager bias.
Small Cap Index Funds:
Small-cap index mutual funds replicate the performance of small-cap indices like Nifty Small-cap 50, 100 or 250. They invest in the same small-cap stocks that constitute the index in the same proportion. The idea is to give investors a means to tap into the high growth potential of small caps through a diversified, low-cost index fund route.
Key Benefits of Investing in Small Cap Index Funds
- Exposure to high growth small cap stocks
- Low cost due to index investing
- Diversification across 100-250 small-cap stocks
- Long-term wealth creation potential
- Transparency and avoidance of fund manager bias
Despite the merits, small-cap index funds have significant downsides that investors must be aware of.
Drawbacks of Small Cap Index Funds
- High volatility compared to large caps
- Risk of capital loss in market downturns
- Require longer investment horizons
- Not ideal for conservative investors
- Poor liquidity in stressful market conditions
Now that both the pros and cons are laid out, let’s dive deep into understanding how these funds work and what investors should keep in mind.
How Do Small Cap Index Funds Work?
As per SEBI rules, small-cap index funds must invest a minimum of 65% of their corpus into small-cap stocks. The fund manager passively tracks an assigned benchmark like the Nifty Small-cap 100 index and buys the same stocks in the same weightage.
For example, if Shoppers Stop constitutes 2% of the Nifty Small-cap 100 index, the fund manager will invest 2% of the fund corpus into it. This is done for all 100 stocks, and a small portion may be kept for liquidity needs in debt and cash equivalents.
The funds keep costs low by avoiding active stock picking and mimicking the underlying index. The funds charge an expense ratio of up to 1%, which covers admin, management, and other running costs.
As underlying small-cap stocks face volatility, the NAVs of these funds tend to fluctuate wildly. In bull runs, spectacular returns can be expected, but bear markets can be equally painful, possibly with deep losses. Hence, investors should assess their risk appetite before investing.
Ideal Investment Horizon for Small Cap Index Funds
Small cap index mutual funds should be invested in for 7-10 years to realise their wealth creation potential. They should be avoided by investors who have short-term goals or have low-risk tolerance. Exposure should also be limited to 5-10% of one’s equity portfolio due to the high-risk, high-reward nature.
Taxation Structure of Small Cap Index Funds in India
Small cap index fund returns attract the following taxes in India:
Capital Gains Tax:
Levied on profits booked when units are redeemed. A short-term capital gains tax of 15% applies if it is redeemed within 1 year. Long-term gains after 1 year attract 10% tax.
Dividend Distribution Tax:
Before dividends are paid out to investors, the fund houses deduct a Dividend Distribution Tax or DDT of 10%. Investors receive post-tax dividends.
Due to indexation and long-term holding benefits, small-cap index funds are tax-efficient instruments for wealth creation over the long run.
Conclusion
Small-cap index funds are a good investment option for those willing to take on more risk. These funds invest in small companies with high growth potential, diversifying your money and reducing costs. However, investing in small caps is risky, so research is key. Conservative investors should stick to large caps. Invest a small portion of your money for long-term growth.
