Small Cap Funds for NRIs: Everything You Need to Know

Are you looking to invest in small cap mutual funds from India? Small cap funds have consistently outperformed large cap counterparts during bull markets. These funds delivered impressive returns ranging from 60% to 100% during market recoveries, including the post-COVID period of 2020–2021. As of August 2023, small-cap funds recorded strong year-to-date returns across many schemes, outpacing large-cap funds.

Small-cap investments require patience and a long-term approach. Small-cap funds require time to manage volatility and realize their full growth potential. This guide explains everything you need to know about small-cap fund investments in India, from understanding how these funds work and their tax implications to analyzing risks and identifying suitable options for your investment portfolio.

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What Are Small Cap Mutual Funds?

Small-cap mutual funds are investment vehicles that focus on companies ranked below the top 250 stocks by market capitalization, as defined by SEBI. These companies represent businesses in earlier stages of development.

These funds work by pooling money from multiple investors and directing at least 65% of this collective capital into small-cap stocks. The Securities and Exchange Board of India (SEBI) has established clear guidelines requiring small-cap funds to invest a minimum of 65% of their assets in smaller companies.

When you invest in small-cap funds, you back companies that haven't reached their full potential. Professional fund managers actively scout for promising smaller stocks that could outperform benchmark indices and large-cap counterparts. Your investment gives you access to businesses with significant room to grow, unlike large institutional investors who focus on established companies.

These funds offer significant diversification benefits. Rather than risking your capital on individual small companies, the fund spreads investments across various sectors and businesses, helping manage the inherent volatility.

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What Every NRI Should Know Before Investing in India

You need to understand several crucial aspects before investing in small-cap mutual funds as an NRI. You must open either an NRE (Non-Resident External) or NRO (Non-Resident Ordinary) account since regular savings accounts aren't permitted for NRI investments under FEMA regulations.

Your choice of account matters significantly. NRE accounts offer full repatriation benefits for both your principal investment and returns, allowing you to transfer them abroad without restrictions.

KYC Requirements for NRIs

You must complete your KYC (Know Your Customer) process before investing. The required documents include:

• Self-attested passport copy
• Overseas address proof
• PAN card
• Recent passport-sized photograph

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Special Considerations for US and Canada-Based NRIs

NRIs from the US and Canada face additional requirements due to FATCA (Foreign Account Tax Compliance Act) compliance. Some fund houses like Aditya Birla Sun Life, ICICI Prudential, and SBI Mutual Fund allow these NRIs to transact only offline, not online.

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Tax Implications for NRIs

Non-Resident Indians (NRIs) investing in Indian small-cap mutual funds, classified as equity funds, are subject to specific tax rules. Short-term capital gains (for holdings up to 12 months) are taxed at 20%, while long-term capital gains (for holdings over 12 months) are taxed at 12.5% on gains exceeding ₹1.25 lakh in a financial year. Importantly, tax is deducted at source (TDS) on these gains at the time of redemption, which is at 20%.

However, if your country has a Double Taxation Avoidance Agreement (DTAA) with India, you may be able to claim relief and avoid being taxed twice on the same income.

Always ensure your Know Your Customer (KYC) information is up to date and consult with your fund house or advisor for the latest compliance requirements.

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Key Risks to Consider Before Investing in Small Cap Funds

Small cap funds carry significantly higher risks compared to large cap investments. Understanding these risks helps you make informed investment decisions.

Volatility Risk: Small cap funds experience much higher price fluctuations than large cap funds. Historical data shows these funds can drop 40–50% during market corrections, as witnessed during the 2008 financial crisis and 2020 COVID crash. This volatility can test your patience and investment discipline.

Liquidity Risk: Many small cap stocks trade in lower volumes, making it difficult for fund managers to buy or sell large positions without affecting market prices. During market downturns, fund managers might struggle to meet redemption requests without selling at unfavorable prices, potentially impacting your returns.

Business Risk: Small cap companies typically have less diversified revenue streams and concentrated business models. These companies are more vulnerable to sector-specific downturns and competitive pressures. Many lack the financial resources of larger corporations to weather extended economic challenges.

Currency Risk for NRIs: Even if your small cap fund performs well in rupee terms, depreciation in the INR could erode returns when converted back to your home currency. This additional layer of risk requires careful consideration for overseas investors.

Management Quality Risk: Small companies often have less experienced management teams and weaker corporate governance structures. Research indicates nearly 60% of small cap companies have family-dominated boards, potentially leading to conflicts of interest that can affect company performance.

Economic Cycle Sensitivity: Small cap funds are particularly sensitive to economic cycles. They typically underperform during economic contractions but can outperform during expansions. This cyclical nature requires strategic timing and patience.

It is essential to assess your risk tolerance carefully before investing in small cap funds, especially given their volatile nature and the additional complexities faced by NRI investors.

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Conclusion

Small cap funds allow NRIs to tap into India's growth by investing in emerging companies, offering strong returns during recoveries but requiring a long term, disciplined approach.

Start with proper account setup. NRE accounts allow full repatriation, while NRO accounts have transfer limits. Complete KYC early, as SEBI permits continued investing for registered NRIs until 2025.

Given their higher volatility and liquidity risks, small caps should form only 15 to 20 percent of your portfolio. Plan for taxes: long term gains are taxed at 10 percent, with TDS on redemptions. DTAA benefits can help avoid double taxation.

Invest for at least five to ten years and consider SIPs to manage volatility. If you have a high risk appetite and long term outlook, small cap funds may suit you, but always consult a financial advisor before investing.

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Frequently Asked Questions

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Q1. Can NRIs invest in small cap mutual funds in India?
Yes, NRIs can invest in small cap mutual funds in India through NRE or NRO accounts. However, they need to complete KYC requirements and be aware of specific tax implications, including a 12.5% long-term capital gains tax on holdings exceeding 12 months.

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Q2. What are the risks associated with small cap fund investments?
Small cap funds carry higher risks due to increased volatility, liquidity challenges, and business risks. They can experience significant drops during market corrections and are sensitive to economic cycles. NRIs should also consider currency fluctuation risks.

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Q3. How long should I hold my small cap fund investments?
It's recommended to have a long-term investment horizon of 5–10 years for small cap funds. This timeframe allows the investments to weather market downturns and realize their growth potential while managing volatility.

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Q4. What are the tax implications for NRIs investing in small cap funds?
NRIs face a 12.5% long-term capital gains tax on equity-oriented mutual funds held for over 12 months, with gains exceeding ₹1.25 lakh. Short-term gains (less than 12 months) are taxed at 20%. TDS also applies when redeeming units.

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Q5. What percentage of my portfolio should I allocate to small cap funds?
Financial experts typically recommend limiting small cap fund allocation to 15–20% of your overall portfolio. This approach helps balance the potential for high returns with the higher risks associated with small cap investments.

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