Small cap mutual funds: A surprising income generation opportunity worth exploring

Small-cap stocks, typically defined as companies with a market capitalization of less than Rs 2 billion, are often overlooked as an income-generating opportunity in India. However, small cap mutual funds that invest in these smaller companies can provide surprisingly high dividend yields. For investors looking to supplement their income, small cap funds are worth exploring.

High dividend potential

While large cap stocks are typically seen as the stalwart dividend payers in India, small cap stocks have the potential to provide even higher dividend yields. Smaller companies attempting to attract Indian investors may use dividends as an incentive. It’s not uncommon to find small cap funds in India with dividend yields of 3-4% or more.

Rising dividends

Like with Indian large cap stocks, investors should look for small cap funds in India focused on companies with a consistent track record of increasing their dividends over time. Most small cap Indian funds have increased their dividends by an average of over 10% annually. For income-seeking investors, a proven willingness and ability to raise dividends is key.

Volatility and diversification in India

While Indian small cap funds have the potential for strong income and growth, they also tend to be more volatile. The companies are smaller, often younger, and more speculative. To mitigate risk, investors should consider small cap funds in India as part of a balanced portfolio that includes large cap, value, and dividend stocks as well.

How to mitigate risks while investing in small cap funds

  • Diversify across funds

Invest in multiple small cap funds instead of just one. This reduces risk exposure to any single fund or fund manager. Look for funds with different investment strategies and holdings. You can do this by way of an SIP to take advantage of small cap funds. Before investing in such funds, you might want to consider using an SIP calculator to determine how much you would need to invest to meet your financial goals.

  • Focus on value and quality

Choose small cap funds that focus on high quality companies with steady cash flows and dividends. Value funds that look for undervalued strong companies are safer than pure growth funds.

  • Take a long-term approach

Small cap funds can be volatile, so invest for the long term. This allows time for the ups and downs to even out, and for the power of compounding to work. Don’t invest money you may need in the next 5 years.

  • Keep allocations moderate

Limit your allocation to small cap funds to 10%-20% of your total equity portfolio. They should not make up the majority of your stock investments because of the higher risk.

  • Rebalance periodically

Review your small cap funds periodically and rebalance as needed to maintain target allocations. Trim allocations if a fund has outperformed significantly, as that often means it has become riskier. Add to underperforming funds to buy at low prices. If you have invested through an SIP, you could opt for different types of SIPs depending on the market condition. If the conditions are favourable, you could invest in underperforming funds by way of a step up SIP, increasing your investments at periodic intervals.

The bottom line

For income investors seeking new opportunities in India, small-cap mutual funds are worth a closer look. They have the ability to generate higher dividends and long-term income growth. While volatile, small-cap funds in India can play an important role in a diversified portfolio. For those willing to stomach some additional risk, the income generation potential of small-cap funds in India may be surprisingly rewarding.

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