Small Cap Index Has Corrected. Good Time to Invest in Small Cap Funds Now?

In CY2024, over 1.05 crore new investors (with unique PAN) were added, which represents a 25% over CY2023 according to the AMFI data. This is the highest edition ever and is despite the markets facing several headwinds and increased volatility.

A majority of the individual investor folios are in equity-oriented mutual fund schemes and investors are mainly approaching Mid Cap Funds, Small Cap Funds and Sector & Thematic Funds.

Small-cap funds, in particular, have witnessed the highest monthly inflow in the past 18 months. This is because, by and large, Small Cap Funds have demonstrated their ability to generate better returns. However, much of the impressive performance has also come during favourable market conditions.

Now the Indian equity market has hit turbulence with the BSE Sensex down nearly 12% and the BSE Small Index nearly 18% since their respective peaks. A variety of factors are at play, such as:

• Trumponomics 2.0 with its protectionist policies

• Trade wars, trade slowdown and stringent immigration rules

• The launch of DeepSeek by China, a low-cost AI model that could change the face of AI and pose a challenge for global AI leaders,

• Geopolitical tensions in many parts of the world

• The ongoing Russia-Ukraine war

• Increasing chances of geoeconomic fragmentation

• Climate risk

• Chances of inflation moving due to higher tariffs and climate risk

• Limited room for central banks to cut rates

• Foreign Direct Investment (FDI) flows slowing down

• Corporate earnings entering the slow lane from Q2FY25

• Higher bond yields

• Weak rupee compared to the greenback

• Foreign Portfolio Investors (FPIs) pulling out money

• ...and more!

These undercurrents have had a bearing on the performance of Small Cap Funds of late. While this may not be evident on rolling returns, on point-to-point returns over the last 6 months certain Small Cap Funds such as Aditya Birla SL Small Cap Fund, Quant Small Cap Fund, Baroda BNP Paribas Small Cap Fund have fallen over 15% (as of January 28, 2025), much more than their benchmark index.

That said, over longer periods, 3 years and 5 years, certain Small Cap Funds have rewarded investors well on a risk-adjusted basis.

Small Cap Funds, as a sub-category of equity mutual funds, hold the potential to generate alpha, i.e. outperform the benchmark, but the key is selecting a scheme that fares well not just on returns but also manages the risk well to generate the returns by holding worthy portfolio characteristics.

Zeroing on a mutual fund scheme just by looking at returns -- compounded annualised returns or absolute returns (as the case may be) -- and often ignoring the risk involved and disregarding portfolio characteristics, does not guarantee you financial success in the future. Meaning, it is not necessary that the superior past performance of a scheme will replicate or repeat in future. A more holistic approach needs to be followed, and you need to be mindful of the risk involved. Watch this video:

[Read: 3 Best Small Cap Funds for 2025]

Is It a Good Time to Invest in Small Cap Funds Now?

The Small Cap Index-to-Sensex ratio is around 0.6 (as of January 28, 2025) vis-a-vis the long-term median of 0.5. There hasn't been a noticeable drop in this ratio since the 2024 peak. Unless this ratio drops below the long-term median, it cannot be considered reasonable.

The BSE Small Cap Index Price-to-Equity (P/E) ratio currently is 29x (as of January 28, 2025) compared to 34x seen in December 2024.

While some froth has settled here with correction in the small cap index, these levels cannot be considered reasonable or cheap. The valuations in the smallcaps (and midcaps) are higher than largecaps.

If the market corrects from hereon for whatever reasons, including earnings not meeting market expectations, then the correction would be more pronounced in the smallcaps and midcaps. This indicates that there is still a high risk involved.

Investing in Small Cap Fund offers an opportunity to benefit from the high growth potential of lesser-known gems of the equity market, but it would not be prudent to pay a high price for future earnings of smallcap companies which may or may not come through. If earnings do not justify valuations, a further correction cannot be ruled out.

The Investment Strategy to Follow

When investing in equity mutual funds, it would be sensible to devise a Core & Satellite approach now.

Typically allocate around 65%-70% of the equity portion in the best Largecap Funds, Flexi-cap Funds/Multi-cap Funds, and Value/Contra Funds as part of the 'core portfolio'. They shall add stability to the investment portfolio and potentially multiply wealth. But make sure to keep an investment horizon of at least around 5 years.

For the 'Satellite' portion of the portfolio, comprising up to 30%-35% of the equity portion, you may include a couple of best Mid-cap Funds (max 2) and an Aggressive Hybrid Fund.

Fresh investment in a Small Cap Fund can be avoided now as valuations aren't very comforting currently.

But if you are already holding a worthy Small Cap Fund in the portfolio, ensure that it is part of the strategic portfolio and with exposure of no more than 15%-20% to it, provided that you have a high-to-very high-risk appetite and an investment horizon of 7-8 years or more. A longer time frame may alleviate the downside risk if the broader markets correct in the near term (due to any macroeconomic and geopolitical uncertainty in play).

Such a 'Core & Satellite' investment strategy -- which is also followed by some of the most successful equity investors around the world -- shall prove sensible when deploying money into equity funds to address your long-term financial goals.

The core portion shall add stability, while the satellite portion push up the overall returns of the portfolio.

For tactical asset allocation to equity, debt, and gold, a Multi Asset Allocation Fund would also be a meaningful choice now.

Carefully selected mutual funds that align with your investment objective, risk tolerance, the financial goals you wish to address, and the time horizon will help you manage risk and pave the way for financial success. Make sure your mutual fund portfolio is well-diversified (with not more than 8-10 best and suitable schemes) and not over-diversified.

Be a thoughtful investor.

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.