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Small-cap funds present unique growth opportunities for investors to invest in new and emerging companies and experience growth. However, they also come with risks and heightened volatility that investors must consider before making an investment in small-cap funds. In this blog, weโll take a deep dive into the world of small-cap funds.
According to SEBI, a small-cap fund is a type of equity mutual fund that primarily invests in small-cap stocks, or companies with a market capitalization of under โน5,000 crore and ranked 251st or below.
SEBI mandates that small-cap mutual funds invest at least 65% of their capital in small-cap companies. Their smaller size and early-stage nature offer significant growth potential but also increase susceptibility to market fluctuations.
Some top small cap mutual funds include Bandhan Small Cap Fund, Nippon India Small Cap Fund, Quant Small Cap Fund, Tata Small Cap Fund, etc.
Key Risks of Investing in Small Cap Funds
Some of the common risks associated with investments in small-cap funds are mentioned below:
1. Market Sensitivity and Economic Vulnerability
Small-cap stocks are highly sensitive to market downturns and economic fluctuations. As a result, during market corrections, small-cap funds often incur sharper losses as compared to large-cap funds.
For example, till May 2025, small-cap mutual funds have seen negative returns of 18%, with an average loss of approximately -11.7% across the category, compared to moderate returns or smaller losses seen in large-cap funds. This reflects their vulnerability to economic cycles and market sentiment shifts.
Small-cap stocks generally have lower trading volumes, meaning there are fewer buyers and sellers at any given time. This makes it challenging to buy or sell large quantities of small-cap stocks without impacting their prices.
Recent stress tests mandated by SEBI revealed that liquidating 50% of a high-risk small-cap mutual fund portfolio could take between 25 and 57 days. As compared to large-cap funds, this period is significantly longer, indicating higher liquidity risk and potential exit challenges with small-cap funds during stressful market conditions.
For example, the Axis Small Cap Fund would require 25 days, while the HDFC Small Cap Fund would need 57 days. Quant Small Cap Fund could take up to 73 days under stressed conditions.
3. Limited Information and Research Coverage
Small-cap companies are often not as closely followed by analysts, leading to less available information and higher uncertainty for investors. This lack of information increases the risk of investing in companies with weak governance or undisclosed vulnerabilities.
Therefore, during investing in small-cap funds, investors rely heavily on fund managersโ research capabilities, increasing the risk associated with their investments.
Small-cap funds are among the most volatile in the Indian equity market. Because of this higher volatility, their returns can be extreme in both directions, ranging from significant gains during bullish phases to steep losses in bear markets.
5. Business and Management Risks
Small-cap companies in India often face challenges like limited scale, dependence on a few key customers, lack of diversification, and management inefficiencies. These risks are amplified during economic downturns. Also, many small-cap stocks have higher promoter holding, implying concentrated control and a higher correlation of company fortunes to promoter decisions.
Small Cap Funds can give rewarding gains but demand discipline, patience, and informed decision-making. By understanding the risks associated with small-cap funds, investors can better align small-cap funds with their financial goals. They are best suited for investors who can weather volatility, maintain a long-term outlook, and avoid reacting impulsively to market movements.
