Your Questions Answered: What are pros and cons of investing in mutual funds tracking Nifty Smallcap 50 Index?

Q. I am a senior software developer at a multinational corporation, and my wife is also a software developer in the same company. We have been investing in large-cap mutual funds for the past 7 years. However, we now wish to diversify and invest in the small-cap segment. Many of our acquaintances have suggested that we should invest in the Nifty Smallcap 50 Index. We are not very familiar with the smallcap segment, can you please elaborate on the pros and cons of investing in mutual funds tracking the Nifty Smallcap 50 Index?

Aviral Karyakarte, Pune, Maharashtra

The Nifty Smallcap 50 Index is one of the most important indexes of the small-cap sector of the Indian stock market. It represents the performance of the top 50 small-cap companies. The companies forming part of the index are selected based on several factors, including whether their average daily turnover is in the list of top 50 companies taken from the top 150 companies based on market capitalisation from the Nifty Smallcap 250 universe. This index allows investors to take advantage of the high-growth potential of smaller companies in India, which are often classified by innovation and significant expansion opportunities.

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Constituents and selection basis

The National Stock Exchange (NSE) came up with certain factors to choose the top 50 small-cap companies that comprise the Nifty Smallcap 50 Index. This is done to make sure that this index only includes small-cap companies that are top performers. Here are the key requirements a company must meet to be a part of the Nifty Smallcap 50 Index:

Listed on the NSE: Any company that wants to be in this index has to be listed on the NSE mainboard. This is necessary because the Nifty Smallcap 50 Index is meant to measure how well the top 50 smallcap stocks on the NSE are performing.

Being a part of the Nifty Smallcap 250 universe: Any company to be part of the Nifty Smallcap 50 Index must first be part of the Nifty Smallcap 250 universe. The largest listed companies on the NSE ranked between the 251st and 500th position based on market cap are included in the Nifty small cap 250 index.

Market capitalisation and turnover: The companies are selected for the Nifty Smallcap 50 Index based on their full market capitalisation and average daily turnover over the last six months. This criterion should be read in conjunction with the other criterion, i.e., the companies that form a part of the Nifty 250 Smallcap universe are filtered out further based on their past 6-month average daily turnover and market capitalisation.

Free-float market capitalisation: The free-float market capitalisation method is used to determine the market capitalisation of eligible companies. In other words, the level of the index reflects the performance of its constituents based on their free-float market capitalisation, and not their entire market capitalisation value.

Review and re-balancing every six months: The index is evaluated at a time interval of six months. This exercise is undertaken in January and July. Thereafter, after the last trade day/working day of March and September, the rebalanced index comes into effect.

Performance and returns comparison with Nifty50

As of July 15, 2024, the Nifty Smallcap 50 Index had a one-year return of 72.47%. It has given a 5-year total return of 203.90%. On the other hand, as of July 15, 2024, the Nifty 50 Index has given a one-year return of 25.72%. It has given a 5-year total return of 112.26%. Please see below the top 3 index mutual funds (direct schemes) tracking the Nifty Smallcap 50 Index based on their assets under management (AUM).

Source: AMFI website; all data as of 12 July 2024.

Note: Past performance is not an indication of future returns.

Benefits

Investing in index mutual funds tracking the Nifty Smallcap 50 Index offers several benefits. Below are the key benefits:

Diversification: Investing your money into an index mutual fund that tracks the Nifty Smallcap 50 Index gives you diversification in the form of investments in 50 different small-cap companies in many different industries. Since the index fund’s success isn’t tied to just one company, this diversification helps lower the risk associated with investing in individual stocks.

Potential for high growth: Historically speaking, small-cap companies have grown faster than large-cap companies. By putting their money into an index fund that tracks the Nifty Smallcap 50 Index, investors can potentially see their money grow at a higher pace, as these companies have more potential to expand and grow than their large-cap peers. However, it is important to note that past returns are not indicative of future returns.

Cost effective: Index mutual funds are passively managed, which means they try to match the success of the index they track instead of taking risky bets to outperform the index. Passive index funds, therefore, have lower expense ratios than actively managed funds.

Transparency: The constituents that make up the Nifty Smallcap 50 Index are open to the public, so buyers can see exactly where their money is being invested. This transparency helps investors make informed decisions and understand where their money is being deployed.

Ease of convenience: It is relatively easy and simple to invest in index mutual funds. Investors can buy units in the fund through a number of channels, such as zero brokerage platforms. Investors can easily invest in index mutual funds through these platforms, all they need to open their account with such platforms is their PAN and bank account details.

Risks

There are certain risks associated with investing in index mutual funds tracking the Nifty Smallcap 50 Index. We have mentioned the key risks below:

High volatility: Historically speaking, the majority of the time, small-cap stocks are less stable than their large-cap peers. Because of higher volatility, the value of the investment in an index mutual fund tracking a small cap index can change at a frequent pace, which makes it a riskier investment choice, especially for investors with a low-risk appetite.

Market risk: Index mutual funds tracking the Nifty Smallcap 50 Index are subject to market risk, just like any other stock market investment. The mutual fund’s success can be compromised by changes in market sentiment, economic downturns, and other macroeconomic factors.

Who should invest in index mutual funds that track the Nifty Smallcap 50 Index?

For some investors, it can be a smart move to invest their money into index mutual funds that track the Nifty Smallcap 50 Index. The goal of these funds is to match the performance of the Nifty Smallcap 50 Index. We have listed below the class of investors for whom these funds are best suited for:

Investors with a higher risk appetite: Small-cap stock prices can be highly volatile, as these stocks are known for frequent price fluctuations. These stocks can potentially generate high returns, but they also have higher risks than large or mid-cap stocks. Investors who are okay with market changes and are willing to take on high amounts of risk are best suited for these funds. Even though the chance of higher gains can be appealing, investors should also be aware of the downside.

Long-term investors: Small-cap businesses can grow at a faster rate than their larger counterparts. However, it may take some time for them to achieve an optimal growth rate. Small-cap funds are better for investors who have a long-term vision, usually five years or more. Small-cap businesses can reach their potential over a longer period, which takes care of the short-term volatility.

Investors seeking diversity: Adding small-cap index funds to a diverse portfolio can help it earn more money and spread out the risk. These funds give investors access to a part of the market that large-cap or mid-cap funds might not cover. Diversification can help keep the portfolio balanced and could even lead to better risk-adjusted results.

Cost-conscious investors: Most of the time, index mutual funds have lower cost ratios than actively managed funds. They do this because they copy the index instead of letting fund managers choose stocks. These funds might be a good choice for investors who want to save money on expenses charged by mutual funds.

Investors who are looking for high growth: Small-cap index funds can be a good choice if your investing goal is to increase your capital at a rapid pace. Small-cap companies often spend their profits to grow their businesses instead of giving them out as dividends, so these funds are geared towards growth.

Taxation

Index mutual funds that track the Nifty Smallcap 50 Index may be a good choice for people who want to spread their portfolio and take advantage of the bigger companies’ potential. But knowing how these things are taxed is important if you want to get the most out of them and follow the rules for taxes. It’s important to know how these investments are handled in India.

Different kinds of gains and how they are taxed

You can divide your results from mutual funds into two groups: short-term capital gains (STCG) and long-term capital gains (LTCG).

STCG: The gains are short-term if you sell your equity mutual fund units less than a year after investing in them. There is a flat 15% tax on these gains.

LTCG: Gains from mutual funds that you keep for more than a year are called long-term gains. Up to ₹1 lakh in long-term capital gains are not taxed in a financial year. Gains over ₹1 lakh are taxed at 10%, and they don’t get the indexation benefit.

The dividend distribution tax

When an owner gets dividends from mutual funds, they are added to their income and taxed at the rates for their income tax slab. This means that if your tax rate is higher, you might have to pay more tax on the income you get.

Conclusion

The Nifty Smallcap 50 Index provides a unique opportunity for investors to tap into the high-growth potential of small-cap companies in India. Although the index is characterised by higher volatility and risk in comparison to midcap and large-cap indices, the potential for significantly higher returns makes it an attractive option for those who have a high-risk appetite.

By understanding its constituents, market representation, and past performance, investors can make informed decisions and strategically incorporate small-cap stocks into their portfolios. Investing in index mutual funds tracking the Nifty Smallcap 50 Index has many benefits, such as growth potential, diversification, low costs, openness, and ease of funding making them a potentially lucrative investment. However, it comes with some risks, such as more volatility, market risk, etc.

Investing in funds that track the Nifty Smallcap 50 Index can be beneficial for investors who are willing to take on a lot of risk, want to stay invested for the long term, and want their money to grow potentially at an optimal pace. Before making any investment choices, you should always think about your personal financial goals, how much risk you are willing to take, and your investment strategy. One should carefully think about how much danger you are willing to take, your investment goals, and how long you have to make an investment.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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