Small-Cap Mutual Funds | Features, Benefits and Taxation Rules

What are Small-Cap Mutual Funds?

Small-cap Mutual Funds are a category of mutual funds that primarily invest in stocks of small companies with small market capitalisation. These companies are relatively smaller in market capitalisation, as compared to Large-cap and Mid-cap companies. According to SEBI, a small-cap fund is required to invest 80% of the total assets in small-cap companies. Small-cap funds have gathered the eyes of investors for the last 8-10 years. In some cases, they have given tremendous returns in the long run, and they have even outperformed large-cap funds and mid-cap funds. However, the higher the return higher the risk.

Small-cap funds are very sensitive and volatile, and they fluctuate very rapidly, they face high price fluctuation in case of any distress or unfavourable event, which can cause the investor to lose his principal investment. There are lots of small-cap fund options available, some of the examples are Axis Small Cap Fund Direct-Growth, ICICI Prudential Small-cap Fund Direct Plan-Growth, Nippon India Small Cap Fund Direct-Growth, Edelweiss Small Cap Fund and many more.

Features of Small-Cap Mutual Funds

1. High Investment in Small-cap Companies: As per the SEBI guidelines, small-cap funds have to invest 80% of the total assets in small-cap companies, and they can use the rest composition to invest in large-cap, mid-cap, or any other asset class.

2. High Returns: Small-cap funds have given very high returns to investors in the long run, they have even given up to 40-50% return in some cases, and they have surpassed the returns provided by large-cap funds.

3. Highly Volatile: Small-cap companies usually show rapid price fluctuations, as they don’t have considerable resources to overcome any distress situation like large-cap companies, and the effect of distress becomes easily visible on the fund’s performance.

4. Cost of Ownership: Fund managers or AMC (Asset management companies) usually levy annual charges from investors, which affect the actual return yield from the investment. SEBI has provided that not more than 2.50% shall be charged as annual charges. These charges are popularly termed the Expense ratio.

5. Lump-sum Investment is Restricted: In the case of small-cap mutual funds AMC (Asset management companies) have halted new inflows in the form of lump sum investments, and they are accepting only systematic investment and systematic transfer plans in order to maintain effective deployment of the funds by fund managers as it becomes difficult to deploy resources when asset under management goes high.

Benefits of Small-Cap Mutual Funds

1. Diversification: As the quantum of available small-cap companies is high and the fund is invested in different companies of different sectors like Financing, IT sectors, Hospitality, FMCG, banking, etc. This makes the portfolio diverse and allows better correlation for investors.

2. Tremendous Growth Rate: Small-cap mutual funds have a very big potential to achieve substantial growth rates for their investors. Small-cap Mutual funds have given better returns than large-cap and mid-cap funds.

3. Divided Risk: Under small-cap mutual funds, the investment is made in different industries and not all industries react similarly to market conditions, so even in case, one industry suffers distress, the other industry might remain unaffected by such distress, which somehow balances the risk equation and provides optimal returns.

4. Low Scrip Cost: Small-cap companies don’t have huge valuations, and their individual scrip values are also nominal compared to large cap, which allows investors to acquire more units of the fund and makes your overall holding significant and influential. This is also termed as Net Asset Value (NAV).

5. Undervalued: Many Small-cap stocks are new to the market and are unexplored by investors, hence they are available at a lower price to acquire, which can prove to be a profitable trade for investors as they have substantial growth potential and even in cases where investors can reap the seed if these small-cap companies get merged or acquired by a large cap/ other companies.

Taxation rules for Small-Cap Mutual Funds

It is important to grasp the taxation implication of any investment in order to substantiate whether taxation implications are in line with your desired portfolio strategy, otherwise, the fruit of investment won’t be sweet. So, in mutual funds, the taxation rules depend upon two factors, 1.  type of mutual funds and 2. the holding period of the respective mutual fund. As small cap mutual funds are equity oriented, they have the following tax implications:

1. Short-term Capital Gain: If the holding period is less than 1 year, then the holding will be considered as short term, and any capital gains arising on such holding will be taxed at 15%.

2. Long-term Capital Gain: If the holding period is more than 1 year, then the holding will be considered as long term, and any capital gains arising on such holding will be taxed at 10%, and no benefit of indexation will be allowed (LTCG up to 1 lakh are exempted).

3. Security Transaction Tax: On the purchase of a mutual fund, STT (security transaction tax) at the rate of 0.001% is to be paid.

4. Dividend Distribution Tax: On any receipt of a dividend, DDT (Dividend Distribution Tax) is to be paid @10% (Exempted if the dividend received is up to ₹5,000).

Conclusion

There are a lot of opinions going around the market, some say investing in small cap funds is risky and some say not investing in small cap funds is risky, investor has to balance his/her priorities along with his/her investing objective. Small cap funds have proved to give higher returns, but they have a big risk factor associated with them. If an investor has the risk-bearing ability, then he may deploy a significant value of his/her investment in small-cap mutual funds, if he is not aggressive, then he may deploy a smaller amount of his/her investment value in small-cap mutual funds.