Should you invest in small cap funds for income generation?
Mutual funds are known to offer capital appreciation over the long term and have been consistently outperforming conservative scheme in terms of offering returns to its investors. While conservative schemes like bank FDs are offering 4 to 7 percent returns, equity mutual funds have offered 15 to 19 percent returns. What distinguishes these two is that mutual funds do not offer fixed returns while bank FDs do. Market regulator SEBI defines mutual funds as, “a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document. Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced.”
SEBI has further categorized mutual funds based on its unique attributes like what assets they choose for their portfolio, how much risk they take for earning returns, what is their investment objective etc. Some of the most sought after mutual fund investments refer to equity, debt, hybrid, ELSS, gold, ETFs etc. An equity mutual fund is an open ended scheme that predominantly invests in equities for income generation. Equity mutual funds are further sub categorized as large, mid, small and multi caps depending on the market capitalization they choose for picking stocks.
- A large cap fund invests in blue chip stocks
- A mid cap funds invests in stocks of companies with medium market capitalization
- A small cap fund invests in companies that are ranked from 250th and downwards in terms of market capitalization
- A multi cap scheme invests in stocks of companies with small, mid and large market cap
What are small cap funds?
As stated earlier, a small cap mutual fund is an equity scheme that invests in stocks of companies with small market capitalization. These funds are considered to be risky as they offer very less liquidity and are more volatile than both large and mid cap funds. As per SEBI guidelines, a small cap fund must invest a minimum of 65 percent of its total assets in mid cap stocks to achieve its investment objective.
Should you invest in small cap schemes?
Since small cap funds carry a high risk return trade off, investors with high risk appetite can consider investing in these market linked schemes. One should realize that investing in small cap funds over the short term might not allow them to earn better capital appreciation, hence in order to allow your portfolio to grow, you must keep a long term investment horizon while investing in small cap funds. Do understand that small cap funds do not guarantee capital gains. So, investors should not depend on only one asset class or market cap for achieve their life’s financial goals. Also, there is a chance of losing your money as well which is why most financial advisor recommend to only invest what you can afford to lose.
To neutralize the investment risk, you can consider starting a monthly SIP in small cap funds. A Systematic Investment Plan will assure that you continue investing a fixed amount every month towards a small cap fund of your choice. If you are skeptical about the fund’s performance, you may stop your SIP investments and switch to a better performing scheme. Some AMCs even have the option of starting a monthly SIP of an amount as low as Rs. 500 per month.
To conclude, small cap funds might offer capital appreciation over the long term but since these are a high risk investment, investors are expected to first consult a financial advisor before investing.