What is a Small Cap Fund? Meaning, Risks & Best Time to Invest

In FY 2023–24, small-cap mutual funds saw a net inflow of ₹40,000 crore in India, according to AMFI data. This alone proves how Indian investors are getting attracted to high-growth potential investments. One of the most talked-about investment options in recent times is the small-cap fund.

Small-cap funds invest in companies that are relatively smaller in market capitalisation but have the potential to grow rapidly. These companies are usually ranked below 250 in terms of market cap on the stock exchange. As per SEBI classification, any company with a market capitalisation of less than ₹16,000 crore is termed a small-cap.

Now, let’s explore this concept in a story-based format.

Meet Arjun: The First-time Investor

Arjun, a 30-year-old working professional in Noida, wanted to start investing for wealth creation. After learning about large-cap and mid-cap funds, he stumbled upon small-cap funds. But the high returns and equally high risks made him curious. “Is this worth it?” he asked his friend Ravi, a seasoned investor.

Ravi smiled and said, “Let me explain…”

What is a Small-Cap Fund?

A small-cap fund is a mutual fund that primarily invests in companies with small market capitalisation, usually below ₹16,000 crore. These companies have high growth potential because they are in the early stages of development. However, they are also more volatile than large-cap or mid-cap companies.

Let’s say you invest ₹1,00,000 in a small-cap fund in 2018. If the fund grows at 20% annually, in 2023, your investment would be worth:
 

₹1,00,000 x (1.20)^5 = ₹2,48,832
 

That's nearly 2.5x your investment in 5 years is impressive. But the risk is equally real. Some years, the returns could be -10% or even -20%.
 

Key Features of Small-Cap Funds
 

• Higher Growth Potential: These funds aim for higher capital appreciation over the long term.
   
• Volatility: Returns can swing sharply due to economic or industry factors.
   
• Better for Long-Term Investors: Ideal for those who can invest for 7–10 years.

Comparison of Fund Types
 

The following table compares the core characteristics of different mutual fund types based on market cap. This helps in understanding where small-cap funds fit in the risk-return spectrum.
 

As is evident, small-cap funds demand a longer time horizon to potentially justify their higher risk with superior returns.

Advantages of Investing in Small-Cap Funds

Arjun was intrigued to know why people invest in these funds despite the risk. Ravi explained:
 

• Exponential Returns: Small companies have more room to grow.
   
• Early Market Opportunities: Investing early in a good company can be rewarding.
   
• Diversification: It balances your portfolio with aggressive components.
   

If Company A in a small-cap fund goes public at ₹100 per share and grows to ₹500 in 3 years, that's a 400% return. But remember, not all companies achieve this.

Who Should Invest in Small-Cap Funds?

Ravi asked Arjun, “Are you okay seeing your ₹1,00,000 become ₹70,000 during bad years, but ₹2,50,000 in good ones?”
 

If your answer is yes, and:
 

• You have a long investment horizon
   
• You can stomach volatility
   
• You want high returns
   

Then small-cap funds may suit you.

How to Start Investing in Small-Cap Funds?

Ravi guided Arjun step by step:
 

• Choose a trusted fund house (like SBI, HDFC, Axis).
   
• Compare the past 5-year performance.
   
• Start with SIP (Systematic Investment Plan).
   
• Monitor quarterly but don’t panic-sell.
   

Popular Small Cap Funds and Their 5-Year Returns
 

This table showcases some of the top-performing small-cap funds to give you a starting point for research. Past performance is not indicative of future results.
 

Insights from the table - A SIP of ₹1,000 in Nippon for 5 years could grow to ₹91,500. Consistency in investing is more crucial than the amount.

How Small Cap Funds Compare to Other Mutual Funds?

Small-cap funds are risky but rewarding. Compared to:
 

• Large Cap Funds: Safer, lower return.
   
• ELSS (Tax Saving Funds): Locked in for 3 years.
   
• Index Funds: Passive, market-linked returns.
   

Mixing 20–25% small-cap stocks in your overall mutual fund portfolio can work wonders.

Conclusion

Small-cap funds offer an impressive avenue for significant long-term wealth building, albeit with greater volatility. Their ability to identify and capitalise on new companies before they become market leaders provides a distinct growth opportunity unrivalled by large-cap investors. While short-term volatility can be dramatic, a disciplined approach, particularly through SIPs, helps to limit timing risks and harness the power of compounding over a 7-10 year horizon.

These products are best suited for investors with a high risk tolerance and the patience to weather market cycles. Small-cap funds, when intelligently combined with other asset types, can dramatically improve portfolio performance. Remember that the key to achieving exponential development is to accept measured risk rather than seeking safety. Stay involved, aware, and let time turn volatility into value.

FAQs about Small Cap Funds

Is it safe to invest in small-cap funds now in 2025?
Small-cap funds are for long-term goals, and if your horizon is 7–10 years, any time is good. Start with SIP to reduce market timing risks.

Can I invest in small-cap funds for 3 years?
Ideally no. These funds need time to grow and smooth out volatility. 3 years is too short.

What is the ideal SIP amount to start?
You can start with as low as ₹100–₹500, depending on the fund. Focus more on consistency than amount.

Do all small-cap companies give multibagger returns?
No. Only a few small-cap stocks deliver extraordinary returns. Fund managers help filter the best.

What happens if the market crashes?
Small-cap funds may fall more than others. Stay invested or invest more through SIP during crashes.


 

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LoansJagat Team

‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.