Small cap funds are equity mutual funds that invest your money in small-cap companies. The Association of Mutual Funds in India (AMFI) maintains a list of companies ranked based on market capitalization. Any company ranked 251 and above falls under the small-cap category.

Small-cap mutual funds compulsorily invest at least 65% of the total money collected in these small-cap stocks. They have a lot of room to grow, but their prices can also move sharply. That makes small-cap funds a high-risk, high-reward option. However, you must not confuse “small” with “cheap”. A company’s market capitalisation tells you its size, not whether its shares are undervalued.

Small cap funds can make sense if you are investing for the long term and can handle high volatility. Here’s who should invest:

• Young investors starting early: When you are in your 20s, you can give several years for your investments to grow. It is easier to let the magic of compounding run wild and smoothly ride out short-term market fluctuations.
• Investors with high risk-taking capacity: Small-cap stocks can move sharply when markets are volatile. If you are comfortable seeing your investment rise or fall 15%-20% without massive FOMO to buy more or panic-selling, you have the right mindset for this category.
• Long-term wealth builders: Some small companies may need years to grow. If your financial goals are far off, like buying a house in 10 years or FIRE at 50, then you can benefit most from small-cap compounding.
• Investors looking for high growth: Smaller companies have more room to grow. Some companies from this category even become multibaggers. Adding them to a portfolio can create a good balance if you already have relatively safer investments in, say, Nifty 50 funds or corporate bond funds.

Small cap mutual funds pool money from multiple investors and use it to buy a portfolio of stocks. At least 65% of the fund’s assets mandatorily go into small-cap companies. The remaining portion can be invested in large-cap or other permitted securities. The fund manager decides which companies to buy, how much to invest in each one, and when to sell them.

So when you invest, say, ₹10,000 in a small-cap fund, the split-up may look like this:

Now imagine the underlying stocks grow strongly over the years. Your ₹10,000 could become ₹15,000, ₹20,000 or more. But the opposite can also happen. If small-cap stocks fall sharply, your investment can temporarily drop to ₹8,000 or even lower.

Small cap mutual funds offer various benefits, such as:

• Early entry into future big companies: Many large-cap and mid-cap companies started small. Investing in small-cap funds gives you early exposure to businesses that could possibly move higher.
• Diversification across niche sectors: Many new industries, such as EV battery components, speciality chemicals, and defence component makers, may be available only in the small-cap category. If you only focus on blue-chip stocks, you can miss these opportunities.
• Professional fund management: Researching and picking the right penny stocks on your own can be very difficult. A professional small-cap fund manager handles stock selection for you and can uncover some hidden gems.
• High potential wealth creation: Small companies have more room to expand their business compared to large ones. They can literally double or triple in size in a few years, giving investors major capital appreciation.

Small cap funds are not all sunshine and rainbows. There are risks involved too, such as:

• Business failure risk: Not every small company becomes a successful large company. Since they have tight working capital and limited access to resources, some companies may struggle with competition, debt or weak management. Economic downturns can wipe out small businesses.
• High volatility: When market sentiments change, small-cap stocks see huge price swings. A 25% to 30% fall during a market correction is normal for this category.
• Liquidity risk: Small-cap stocks generally have lower trading volume than bigger companies. So when markets are stressed, it can become difficult for the fund manager to exit certain holdings.
• Prolonged stagnation: Small caps can experience long consolidation phases where stock prices do nothing for 2-3 years. If the market falls just before your withdrawal, it could hurt your portfolio. So it may not be an ideal choice if you may need money in the short term.

How can you handle these risks?

Here are a few things that you can do to manage these risks:

• Invest for at least 7 years: Give your money time to grow. A longer horizon gives your portfolio more time to recover from market corrections.
• Pair with low-risk funds: Balance your risk by adding conservative funds, balanced funds or emergency options like liquid funds to your portfolio.
• Don’t panic sell: Corrections are part of the equity markets. Selling just because your fund has fallen can turn a temporary decline into a permanent loss.

All three are equity funds that invest in companies of different sizes. The right choice depends on how much risk you are willing to take, how long you can stay invested, and what you want from your portfolio. Let’s compare them:

If you want exposure to all three large-caps, mid-caps and small-caps with minimum allocations to each, you can look at multi cap funds. For more flexibility across categories, consider flexi cap funds. And for a passive approach, you can also look into Nifty small cap funds, Nifty mid cap funds or baseline Nifty 50 funds.

The best small cap funds for you are the ones that match your financial goals. Here’s what you should look for to find the right fund for you:

• Compare with its benchmark: The benchmark for small-cap funds is the Nifty Small Cap Index. See whether the fund has outperformed or underperformed the benchmark index over the past few years.
• Look for a consistent long-term record: Don’t pick a fund just because it gave huge returns in the last year. Check how it has performed across several years. There are different cycles in the market. See how the fund has performed through them.
• Check expense ratio and other costs: Ensure that the expense ratio, that is, the fund management fee, isn’t too high. It reduces your returns. You can save by preferring direct plans over regular ones. Also check if any additional charges are involved, like exit loads for early withdrawals.
• Understand the underlying portfolio: A good portfolio is the one that spreads across 40, 50, or more stocks rather than allocating more to a handful of stocks. This diversifies risk across the portfolio in a balanced way.

Before choosing among the best small cap mutual funds, ask yourself: Can I stay invested even if my investment performs poorly for a year or two? If the answer is no, you can consider lower-risk categories, such as large cap funds or flexi cap funds.

Once you’ve picked small cap funds to invest in, starting a SIP on Millions is quick and hassle-free.

• Download the Millions app on your smartphone from the Google Play Store or the iOS App Store.
• Enter your mobile number, submit your basic details, and complete paperless KYC to open a free account.
• Once logged in, search for the curated funds section and pick the small-cap mutual fund scheme you’d like to invest in.
• Tap on “SIP”, select your monthly, weekly, or daily frequency, and enter the amount you'd like to start investing.
• Lastly, select the SIP debit date and authenticate the initial payment.

You’re all set! Taking that first step is a real game-changer. You don’t need a huge bank balance. Even saving a small amount from your pocket money and investing regularly can compound your portfolio over time.