Small Cap Funds for NRIs: All You Need to Know About

Small-cap funds primarily invest in small companies with the potential to grow and generate high returns. Post-COVID, these funds have performed very well. So, being an NRI, if you are planning to invest in small-cap mutual funds in India, then surely it is the right decision.

However, these funds, to know their growth potential and manage volatility, require time. Additionally, also need a long-term approach and patience from investors. To help you out, this blog explains everything about small-cap funds for NRIs, from their benefits to tax implications and top small-cap funds. So read on and gather all the information.

What Are Small Cap Funds?

According to the Securities and Exchange Board of India (SEBI), small-cap mutual funds are investments that focus on companies that rank below 250 by market capitalization. For instance, consider India has 5,000 listed companies, among them 4,750 firms have small caps. These are companies that generally have market caps below INR 5,000 crore ($600 million). These represent the development of business in earlier stages.

These funds operate by taking money from several investors and directing a minimum of 65% of this capital into small-cap stocks. Considering this, SEBI has stated clear instructions for small-cap funds to invest at least 65% of their asset in small firms.

Further, unlike large-cap funds that invest in the top 100 blue-chip companies of India, small-cap funds put their money on emerging businesses at their growth stages. In this, the job of the fund manager is to look for the undervalued firms that have strong growth potential.

Confused, think of it like large caps are hotels established in prime locations, whereas small caps are food trucks that in the future might become a restaurant or go bankrupt while trying.

So, this was all about small-cap mutual funds. Moving ahead, let's know why NRIs should choose small-cap funds over large-cap funds.

Why Should NRIs Opt for Small Cap Funds?

NRIs should opt for small-cap funds instead of large-cap funds because they offer advantages like:

• Room to Grow: Compared to large companies, small companies have more potential to grow. For instance, an INR 500 crore company, by expanding into 2-3 new cities or by winning contracts, has the potential to become an INR 1000 crore firm.
• Underresearched: Unlike 50+ analysts covering Reliance and Infosys, only 5-10 cover most small-cap stocks. This creates mispricing. Considering this, when fund managers get to know about small companies, disproportionately, the early investors get the benefit.
• Nimbleness: Small companies can shift quickly. They take advantage of niche opportunities that are ignored by the large companies. For instance, after post-COVID, many small firms and healthcare companies grow their market share faster than the established firms.
• Multiple Expansion: As the growth potential of small companies proved post-COVID, they move towards mid-cap or large-cap indices. This outcome in institutional buying, such as insurance companies, pension funds, and increasing valuation. In this, you get gains from both- growth of the business and valuation re-rating.

In simple words, small companies have benefits that decades ago large companies have lost. So, this is why NRIs should opt for small-cap funds instead of large-cap funds. Now, moving further, let's know the things NRIs should consider before investing in these funds.

Things NRIs Should Consider Before Investing in Small-Cap Funds

Although small-cap funds are good options for investment. However, compared to large-cap investments, they have higher risk as they are in their initial stage of establishment. Further, understanding these risks helps NRIs make the right decisions before investment.

• Volatility Risk: Compared to large-cap funds, small-cap funds face higher price fluctuations. Data from the past shows that during the 2008 financial crisis and the 2020 pandemic, due to market conditions, these funds dropped to 40-50%. Further, this volatility can test the investment discipline and patience of investors.
• Business Risk: Generally, small-cap companies have less focused business models and diversified revenue streams. Additionally, these are not so effective in handling competitive pressures and sector-specific downturns. Considering this, due to extended economic difficulties, many companies lack the financial resources of large companies.
• Liquidity Risk: Many small-cap funds trade at lower prices. This creates issues for fund managers to purchase or sell large stocks without impacting the market costs. Further, at the time of market downturns, fund managers face difficulty in fulfilling the redemption requests of investors without selling at unfavorable costs, affecting their returns.
• Currency Risk for NRIs: Even in terms of the rupee, if your small-cap mutual funds perform well, when converted back to your resident country, depreciation in the INR could affect returns. Further, NRI investors should consider an additional risk layer.
• Economic Cycle Sensitivity: Small-cap funds are specifically sensitive to economic cycles. During economic contractions, these generally underperform. However, during expansions, they can also outperform. To do so, both patience and strategic timing are vital.
• Management Quality Risk: Compared to large companies, small companies have a weaker corporate structure and a less experienced team of management. Research shows that almost 60% of small-cap firms have family-dominated boards. This potentially outcomes to conflicts of interest that impact the performance of the company.

So, before investing in small-cap funds, it is advisable for NRIs to carefully assess their risk tolerance. Moving ahead, let's know how the NRIs can invest in these funds. 

How NRIs Can Invest in Small-Cap Funds?

Here is how NRIs can invest in small-cap mutual funds:

Step 1: Know Your Residential Status

Before investing in small-cap funds, first know your residential status, i.e., NRI, RNOR, or Indian resident. It is because, according to residential status in India, tax obligations will be imposed on you.

Step 2: Open NRE or NRO Account 

To invest in India, under the FEMA regulations, you need to open either a Non-Resident External (NRE) or Non-Resident Ordinary (NRO) account.

• NRE Account: These accounts offer the benefits of full NRI Repatriation funds for both your returns and principal investment. It allows you to transfer the funds overseas without any amount limitations. 
• NRO Account: The account is for non-repatriable or income earned in India. Under LRS, using this account, you can transfer up to $1 million overseas per financial year. 

Step 3: Complete KYC

Before investing in India, NRIS must complete their Know Your Customer (KYC) process. The required documents:

• PAN Card
• Copy of passport with a valid visa
• Address proof of overseas (bank statement, utility bill)
• Signature specimen
• Recent photograph

Further, due to FATCA (Foreign Account Tax Compliance Act), NRIs from Canada and the US may need to submit some additional requirements. Additionally, some fund houses like SBI Mutual Fund, Aditya Birla Sun Life, and ICICI Prudential allow these NRIs to transit offline only. 

Between SIP and Lumpsum

You have two options to choose between SIP and Lumpsum:

• Systematic Investment Plan (SIP)
  • Monthly invest fixed amount (INR 500 - INR 10,000+)
  • During volatility, the cost of the rupee averages
  • Disciplined approach 
  • For most of the NRIs, it is the best option
• Lumpsum
  • The entire amount is invested at once
  • If you have surplus cash, it is a suitable option
  • Higher timing risk
  • When markets are undervalued, these are better options.

Further, for small-cap mutual funds, it is advisable over lumpsum choose SIP. 

Step 5: Choose the Funds

While choosing the investment fund, look for:

• Constant 5-year returns
• Large AUM (INR 5,000+ crore shows credibility)
• Have a low expense ratio (under 1%)
• Experienced fund manager (tenure of 5+ years)
• Diversified portfolio (50+ stocks, not concentrated overly)

Step 6: Link Your Bank and Begin Investing

Once you link your bank account, through the given options, you can invest:

• Aggregator platforms (Groww, INDmoney, Zerodha Coin)
• Distributor platforms
• AMC websites directly (Nippon India, SBI MF, and more)

This is how NRIs can invest in small-cap funds. Moving further, let's know the NRI income tax in India that NRIs face while investing in these funds. 

Tax Implications for NRIs

Since small-cap funds hold 65%+ in equities, for taxation purposes, these are stated as equity funds. Compared to NRO fixed deposits or debt instruments, this provides NRIs with preferential tax rates.

• Short-Term Capital Gains (Holding period is less than 12 months): 20% + applicable surcharge + 4% education and health cess.
• Long-Term Capital Gains (Holding period is more than 12 months): 12.5% on capital gains more than INR 1,25,000 annually + applicable surcharge + 4% cess.
• Tax Deducted at Source (TDS): When you redeem your units, without considering the holding period, 20% TDS is deducted for NRIs. Further, when filing your NRI tax returns, you can claim the tax credit.
• DTAA Benefits: If the country you are currently residing in has signed the DTAA (Double Taxation Avoidance Agreement), then you avoid paying taxes on the same income twice. You may be able to claim either a tax relief or a tax credit on that income. Further to claim the DTAA benefits, you need to:
  • Obtain a Tax Residency Certificate (TRC) from your resident country
  • Submit TRC and Form 10F to your fund house
  • Under Article 13 (Capital Gains), file your Indian tax return

These are the tax implications NRIs face when investing in small-cap funds in India. Moving ahead, now let's know the top small-cap funds for NRIs.

Top Small Cap Funds for NRIs

Based on the historical performance, track record of the manager, and fund size, here are the top small-cap funds for NRIs: 

So, as per your financial goals and preferences, choose any of these small-cap funds for investment. Further, to reduce the risk of a manager, it is advisable instead of a single fund, diversify across 2-3 small cap mutual funds.

Final Thoughts

Lastly, by investing in small-cap funds, NRIs help in the growth of the emerging companies of India. It further provides them with strong returns during recoveries but needs a disciplined long-term approach. Here, the complete blog was about small-cap funds for NRIs. Hope after reading it all your doubts get resolved.

Further, if you are still confused or need assitance in choosing the right investment plan, connect with Savetaxs. We have a team of financial advisors who have years of experience in NRI investments. Additionally, if you want, they can also help in resolving your tax obligations.