Small Cap Mutual Funds – Meaning, Features, Benefits & Risks

• Sushil Bajaj |
• 25 August 2025 |

For equity mutual funds, there are usually two options in front of them –
“Should I invest in established big companies or seek the higher potential for growth in little companies?” That is where Small Cap Funds enter the frame. These funds have a high-risk, high-return nature and are suitable only for investors willing to hold on for long hauls for long-term returns.

In this article, we’ll break down everything you need to know about Small Cap Mutual Funds – meaning, features, benefits, risks, taxation rules, and more.

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What is Small Cap Fund?

A Small Cap Fund is an equity mutual fund that invests predominantly in stocks of small-cap companies.

According to the Securities and Exchange Board of India (SEBI) guidelines:

• These funds have to hold at least 65% of their assets in small-cap stocks.
• Small-cap companies are those companies that are below 250th ranking in terms of market capitalization.

👉 Simply put, small-cap funds invest in the budding stars of the stock exchange – companies that are small now but could grow into giants in the coming future.

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Advantages of Investing in Emerging Companies

These are the main attributes that distinguish small-cap funds:

High Risk, High Return Potential

• These are very volatile and sensitive to changes in the market.
• During a bull run, they are capable of making benchmark-beating returns, but in a downslide in the market, they could fall sharply.

Long-Term Investment Horizon

• It takes years for businesses to grow.
• Investors must remain invested for at least 8–10 years to unlock the full potential of these funds.

Wealth Creation Opportunity

• Even a small allocation to small-cap funds in your portfolio can significantly boost long-term wealth, provided you stay invested.

Diversification Benefits

• These funds provide exposure to businesses from industries that often are not included in large- or mid-cap funds.

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How Do Small Cap Mutual Funds Function?

• Fund managers allocate at least 65% of the portfolio into small-cap companies.
• The rest can be put in mid-cap or large-cap stocks for stability.
• These funds are actively managed, and stock selection plays a critical role.

The performance depends on:

• Potential for growth of small businesses,
• Fund manager’s expertise,
• Overall market conditions.

👉 Small-cap funds are highly volatile in the short term but, in the long term, have the potential to yield more than a large or mid-cap fund.

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Why You Should Invest in Small Cap Funds?

Some reasons why investors prefer small-cap funds:

✅ Potential for High Returns – Small companies can grow faster than established giants, leading to multibagger returns.
✅ Early-Stage Opportunities – You have access to businesses prior to them turning into mid-cap or large-cap.
✅ Portfolio Growth – Adding a small-cap fund can improve the overall return potential of your investment portfolio.
✅ Long-Term Wealth Creation – Ideal for investors with long-term goals such as retirement, education for children, or building wealth.

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Risks Related to Small Cap Funds

Although the payouts are promising, the funds are not for the faint-hearted.

⚠️ High Volatility – Stock prices of small-cap companies swing more than large-cap or mid-cap firms.
⚠️ Liquidity Risk – Since small-cap stocks are less frequently traded, buying and selling may be affected.
⚠️ Market Downturn Impact – A bear market usually witnesses the maximum decline in small-cap funds.
⚠️ Long Gestation Period – These funds take time to deliver results. Short-term investors may be disappointed.

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Who Should Invest?

Small Cap Funds are appropriate for:

• Investors with a high-risk appetite.
• Long-term investors with a holding period of 8–10 years or more.
• People who want to allocate a small portion (5–15%) of their portfolio for higher growth potential.
• Long-term wealth builders seeking investments.

👉 Not appropriate for conservative or novice investors.

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Rules of Taxation for Small Cap Mutual Funds

Like any other equity mutual fund, there is equity taxation for the small-cap funds:

• Short-Term Capital Gains (STCG): If redeemed within 1 year, taxed at 15%.
• Long-Term Capital Gains (LTCG): These are tax-free if they are held for over a period of 1 year. Gains in excess of ₹1 lakh are taxed at 10% without indexation.
• Dividends: Mutual fund dividends are taxed according to your income tax slab.

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FAQs on Small Cap Funds

Q1. What is a Small Cap Mutual Fund?
A Small Cap Mutual Fund invests at least 80% of its assets in small-cap stocks – companies with market capitalization of less than ₹5,000 crore.

Q2. Are Small Cap Funds risky?
Yes. These are extremely volatile and are highly risky investments. Yet, in the long run, they can provide outstanding returns.

Q3. How long should I stay invested in Small Cap Funds?
Ideally, for 8–10 years to allow small companies enough time to grow.

Q4. Which investors must avoid Small Cap Funds?
Short-term traders, conservative investors, or those in need of stability should avoid these funds.

Q5. What is the difference between Small Cap and Mid Cap Funds?

• Mid Cap Funds invest in mid-sized companies (ranked 101–250 by market cap).
• Small Cap Funds invest in companies below the 250th rank.
• They are riskier but carry higher potential returns.

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Conclusion

Small Cap Mutual Funds are a great wealth-generation tool for long-term players willing to accept short-term volatility in stride. When properly allocated, patiently, and disciplinarily, these funds can make you part of India’s growth revolution through emerging businesses.

But remember:
👉 Invest in just a fraction of your portfolio.
👉 Stay invested for the long term.
👉 Always equate your investments with your risk tolerance and financial objectives.

📌 Disclaimer – Investments in mutual funds are susceptible to market risk. Please read all scheme documents carefully prior to investing.

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