Will Small-cap Funds Continue to Do Well in 2021?

Cheap market valuations around March 2020, Foreign Portfolio Investors (FPIs) pumping money into India (to the tune of over Rs 1.70 trillion), increasing retail participation, plus a series of stimulus packages and reforms to boost consumer demand amidst the pandemic have led to a rally Indian equity markets, particularly in small-caps (and mid-caps).

Various Small-cap Mutual Fund schemes, as result, also fared well on a 1-year period and their longer period returns also improved (see Table 1).

A predominant number of smallcap schemes outperformed the benchmark S&P BSE Small-Cap Total Return Index (TRI) by a noticeable margin. Funds having a considerable exposure to speciality chemicals, pharmaceuticals, Information Technology (IT), and banking & financial service managed to trump their respective benchmark indices and the broader markets.

Besides that, a late rally in metals, capital goods and some of the niche platform businesses helped a few Smallcap Funds such as Quant Small Cap Fund and BOI AXA Small Cap Fund generate stupendous returns over the last one year.

Schemes such as Canara Robeco Small Cap Fund, Edelweiss Small Cap Fund and Principal Small Cap Fund, which were launched in 2019, also reported striking returns with their underlying portfolios performing well.

However, it is not just the right stock selection for many of the schemes launched in the last 2-3 years, but also the time of their launch that has attributed to their remarkable outperformance vis-a-vis the respective benchmark. They were launched at a time when small caps were under the weather and valuations were much cheaper than what they are today.

If we look for consistency, in my view, schemes such as the SBI Small Cap Fund, Axis Small Cap Fund, and Kotak Small Cap Fund have displayed a superior track record across time periods and market phases (bulls and bears) - and not just in 2020. Interestingly, they seem to have benefited immensely from their exposure to sectors such as cement, engineering, chemicals, IT, Fast-Moving Consumer Goods (FMCG), consumer durables, banking & financial services, among others.

A few schemes with a large AUM and not so good portfolio characteristics have featured at the bottom of the list of performers.

Can Small-cap Funds continue to do well in 2021?

As far as the potential performance of small-caps is concerned, a lot depends on their Q3FY21 and Q4FY21 earnings. The gradual return to normalcy from the COVID-19 pandemic may benefit small-cap companies.

The 'helicopter money' (powered by the easy monetary policy actions by the way of near-zero or sub-zero interest rates and bond-buying programmes in the developed markets) would also ensure enough money flows into India, which continues to be an attractive investment destination on FPIs radar.

However, keep in mind that after a sharp +113% rise since the March 2020 low, valuations now are flying high; they look rather expensive. The trail Price-to-Earnings (PE) multiple of the S&P BSE Small-Cap Index is currently nearly 228x (as of January 13, 2021).

Given the emergence of new challenges with the U.K. mutant strain (referred to as 'B.1.1.7', which is highly transmissible); so far 96 cases reported in India (and many more across the globe) plus with persisting geopolitical tensions; the chances of some correction (around 5-10%) followed by intense volatility cannot be ruled out. This will possibly weigh on the small-cap companies. Besides, much hinges on the Union Budget 2021-22 announcements.

How investors should approach Small-cap Funds now?

First, note that Small-cap Funds are placed at the higher end of the risk-return spectrum. They are not for the faint-hearted. Stocks of small-cap companies are highly volatile and have the propensity to go from exciting highs to disturbing lows. Therefore, a Small-cap Fund is a very high-risk-high return investment proposition.

If your risk profile permits, you may invest a certain portion of your equity portfolio in a worthy Small-cap Fund/s only if you have an investment horizon of at least 7-8 years. However in this case to mitigate the volatility, a wiser approach would be to take the SIP (Systematic Investment Plan) route. This way, the inherent rupee-cost averaging feature of SIPs will help you manage the risk better while you endeavour to compound your hard-earned money.

If the Indian equity market corrects from the current highs, which is likely, more units would be allotted against your SIP instalment. When the market begins to ascend again, it would compound your wealth.

If you are looking for a time-tested investment strategy that can help you get the best of both the worlds, i.e., the stability of large-sized companies and high return potential of smaller companies, ideally construct a mutual fund portfolio using the 'Core & Satellite' Approach in the current scenario.

'Core & Satellite' is a strategy followed by some of the most successful equity investors in the world. It helps to build a robust all-weather portfolio.

The 'Core' holding should comprise around 65%-70% of your equity mutual fund portfolio and consist of Large-cap Fund, Multi-cap Fund, and a Value Style Fund.

Whereas, the 'Satellite' holdings of the portfolio can be around 30%-35% comprising of a Mid-cap Fund, a Large-cap & Mid-cap Fund, Small-cap Fund, and/or an Aggressive Hybrid Fund.

You see, following the 'Core & Satellite' Approach to investing bring along six key benefits:

1. Provides optimal diversification

2. Reduces the need for constant churning of your entire portfolio

3. Reduces the risk to your portfolio

4. Helps you benefit from a variety of investment strategies

5. Allows you to create wealth, cushioning the downside

6. Holds the potential to outperform the market

The core and satellite investment strategy may work for you in 2021 and beyond.

That said, it is important to select well-researched mutual fund schemes that offer you stability at the core and the satellite portion helps you accelerate the return.

Happy Investing!

Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter

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