Can Small Cap Funds Deliver Big Returns Going Forward?

As seen in the graph below, the Small and Mid Cap Funds have witnessed higher cumulative net inflows than the Large Cap Funds in the last few years.

These inflows have come in even against the backdrop of the COVID-19 pandemic, looming geopolitical tensions, various macroeconomic factors in play, elevated valuations, and volatile equity markets. Perhaps investors are excited by the returns clocked by the small cap index but are disregarding the risks.

In March 2008, a few months before the Lehman Brothers -- the U.S.'s fourth-largest investment bank founded in 1850 -- collapsed, the Indian equity market landscape had a total of 7 equity funds with AUM of around Rs 2,500 crore.

But nearly a decade later, when the capital market regulator, SEBI, came up with strict mutual fund categorisation and rationalisation norms (so that it become easier for investors to identify mutual funds), several schemes existing schemes having exposure to micro caps as well as combining mid and small caps were merged and/or rechristened as small caps, and the count of Small Cap Funds went up.

Besides, mutual fund houses, which didn't have an independent small cap fund in their product basket, launched New Fund Offers (NFOs) capitalising on the market sentiments. As a result, the number of Small Cap Funds more than doubled from March 2008, and the combined Small Cap Fund AUM today is Rs 28.15 trillion.

Speaking of the performance of Small Cap Funds, the category average returns over a longer period showed an outperformance vis-a-vis the small cap indices. However, the table below shows that not all Small Cap Funds have been able to deliver appealing returns.

The gap or the difference between the top performing Small Cap Fund and the bottom Performing Small Cap Fund is quite noticeable.

Also, not all Small Cap Funds have managed their risk well when managing the returns. For this reason, it becomes important to select Small Cap Funds prudently before adding them to your investment portfolio.

[Read: 5 Best Small Cap Funds for 2024]

The table above shows that during the bear phase of the Indian equity markets in 2008-09 due to the Global Financial Crisis, the average returns of Small Cap Funds plunged. Moreover, there was a noticeable difference between the returns of the top performer and the bottom performer.

Similarly in the brief setback of the COVID-19 pandemic from January 14, 2020, to March 23, 2020, as shown in Table 4, Small Cap Funds, on an average, generated negative returns. Moreover, there was a stark contrast between the returns of the top and bottom performing Small Cap Fund.

In the current bull market rallies since the March 2020 lows of the COVID-19 pandemic, the Small Cap Funds have undoubtedly delivered stellar returns. However, the performance of Small Cap Funds during the bear phases of the Indian equity markets underlines the need to select Small Cap Funds carefully.

Keep in mind that among the various sub-categories of equity mutual funds, the risk of investing in Small Cap Funds is very high. They find their place at the very high end of the risk-return spectrum.

This is because Small Cap Funds, by definition, are mandated to invest at least 65% of their assets in equity and equity-related instruments of small-cap companies, i.e. the ones beyond 250 on a full market capitalisation basis. Usually, these companies have a market cap of less than Rs 5,000 crore and could be less liquid. In other words, investing in small caps is a very high-risk-high-return investment proposition.

The question then arises: Does It Still Makes Sense to Invest in Small Cap Funds in 2024?

In the past, small caps have outperformed and exceeded the returns expectations. Whether it would clock attractive returns in 2024 cannot be said with the most certainty.

At present, India is the most expensive emerging equity market. The Morgan Stanley Capital International (MSCI) India Index Price-to-Equity (P/E/) ratio is over 25x, while the MSCI Emerging Markets Index and MSCI World Index trail P/Es are around 14x and 21x (as per the latest factsheets). Even on a 12-month forward P/E, India is commanding a visible premium vis-a-vis emerging markets and the world. Looking back in time, such expensive valuations were seen even in 2007-08, just before the Lehman Brothers collapse and the Global Financial Crisis.

In the case of midcaps and small-caps, the valuations are relatively even more expensive.

The S&P BSE Smallcap to Sensex ratio, a determinant of valuations in the small-cap segment, currently stands over 0.60 versus a long-term median of 0.44. These levels were last seen in 2018, just before the mid and small-cap crash of 2018-19.

This clearly indicates that valuations aren't cheap, and the margin of safety seems to have narrowed. It would be unwise to get carried away by irrational exuberance and expect extraordinary returns from small caps.

Note that, equity markets move in cycles - a bull phase is followed by corrections or bear phases and vice versa. If things on the economic and political front do not pan out to what markets expect, equities may correct from their current lifetime high levels. In such times, small caps and Small Cap Funds would be more vulnerable or risky. Simply put, they may fall more than the Mid Cap Funds and Large Cap Funds. In other words, they could disappoint you, the investor.

When approaching Small Cap Funds, here are things you should clearly avoid:

• Going gung-ho at a market high

• Zeroing on funds by giving too much weightage to recent past performance

• Expecting super-normal returns to continue

• Keeping the mindset of a trader

• Acting on unsolicited advice from inexperienced individuals

When investing in small caps, you ought to be mindful of the fact that they are less liquid, may have weak cash flows and high leverage, and could have corporate governance issues. Watch this video:

How to Approach Small Cap Funds

Investing in Small Cap Funds is not for the fainthearted, and even if wish to take high risk, you need to follow a sensible asset allocation and have a longer time horizon of 7 to 10 years.

From an asset allocation perspective, Small Cap Funds should not be more than 10-15% of the entire equity portfolio and should be part of satellite holdings (not core holdings) that potentially could push up the portfolio returns.

Whereas the 'Core' portfolio may comprise more stable and long-term holdings (such as a Large Cap Fund, Flexi Cap Fund, and a Value Fund).

[Read: Do Large Cap Funds Make More Sense in An Overheated Equity Market?]

By wisely structuring your mutual fund portfolio (based on your age, risk profile, broader investing objective, the financial goal/s you are addressing, and investment time horizon), you would set the path to wealth creation.

To invest in small-caps, prefer small-cap funds that follow robust investment processes and systems, pay close attention to liquidity, market capitalisation, and hold an optimally diversified portfolio (of around 40 to 60 stocks) with conviction.

Choose a Small Cap Fund scheme that is true to its label. Invest sensibly and be a thoughtful investor.

When in doubt, don't hesitate to reach out to a SEBI Registered Investment Advisor.

Happy Investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.