Risks Associated with a Small Cap Index Fund

Investing in a small-cap index fund can provide you with massive opportunities for growth. At the same time, there are several risks that you will need to be aware of before getting involved with this type of mutual fund. Here are some of the risk associated with a small-cap index fund.

Market Risk

The first risk that you will have to be able to deal with is market risk. Anytime that you invest in stocks, this is going to be the case. You have to be able to put up with market risk in order to make a return. Even though your investment will be diversified over several different companies, there is always the chance that the stock market could crash. When this happens, the value of your investment could plummet drastically.

Less Information

Even though small-cap companies can provide you with good opportunities for growth, there is less information out there about them. This makes it more difficult for investors to accurately ascertain the value of a company. Even though mutual fund managers might have better information than you, this is still a source of risk. If the mutual fund manager does not have the proper information, it could lead to problems in the future.

Volatile

Another potential risk with this type of fund is volatility. Just like the value of these stocks can increase quickly, they can decrease just as quickly. You have to be ready to deal with fluctuating prices on a daily basis. Just when you think your investment is going good, it could turn around quickly.

Liquidity

Liquidity is another issue that you have to be aware of when you invest in this type of index fund. One of the problems with smaller companies is that there is not as much volume in the market. When there are not as many traders, it can be difficult to find people to trade with. If the price of a small-cap company is decreasing quickly, it may be difficult to sell shares. This helps contribute to the volatility of the market overall.

Arbitrage

Another potential risk that you may have to worry about is the risk of faulty arbitrage. With index funds, index fund managers will often try to predict what an index will do. For example, when a company is removed from a financial index, another company will jump up into its place in the index. If someone can accurately predict what company will be added to the index and purchase the stock in advance, they will be able to benefit from a jump in stock price when it is officially added to the index. Many mutual fund companies try to crunch numbers and predict which companies will be added to a financial index. When this happens, they might invest a certain amount of money into the stock prematurely. If they guess wrong, it could end up costing the fund a lot of money.

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