The leading stock market indices, S&P BSE Sensex and CNX Nifty, are near an all-time high. They have bounced back sharply from the lows of March 2018.
However, the fortunes of small-sized companies haven’t changed much; many of them are still in the depths of despair.
Small cap stocks had a free run between 2013 and 2017. Despite the steep fall they have been experiencing since February 2018, many of them have generated high double-digit returns on a 5-year period.
The chart below denotes that although the margin of outperformance has eroded severely of late, the small-cap index has still outperformed the bellwether index.
Are Small-Caps losing their aura?
Data as on August 20, 2018
(Source: ACE MF, PersonalFN Research)
But also notice that the S&P BSE Sensex resumed its upward journey soon after falling from its peak and has managed to cover a lot of ground. On the other hand, S&P BSE Small Cap Index struggled to contain the slide.
Until recently investors were flocking to small-cap mutual fund schemes in search of better returns. The inflow from new investments was so intense that some small-cap and micro-cap mutual funds had stopped accepting fresh investments for the lack of investment alternatives.
Return generate by small-cap funds…
Data as on August 20, 2018
Point-to-point returns depicted. Returns less than 1 year are absolute, while over 1 year are compounded annualized.
(Source: ACE MF, PersonalFN Research)
But everything changed after the capital market regulator, SEBI, came up with the “Categorization and Rationalization of Mutual Fund Schemes” and as result, a number of schemes were renamed and re-categorised. Fund houses in order to adhere to the stringent regulatory guidelines changed the fundamental attributes and aligned the portfolio. Among various market capitalisation baskets, the small-cap universe was the most adversely affected fraternity.
[Read: Your Mutual Fund Scheme Renamed. What Should You Do? ]
What has changed for small-cap mutual fund schemes?
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As per new rules, a small-cap fund has to invest at least 65% of its total assets in equity & equity related instruments of small cap companies. (i.e. companies that are 251st onwards on a market capitalisation basis).
For this, mutual funds are supposed to adopt the list of stocks prepared by AMFI that classifies them as large-caps, mid-caps, or small-caps.
Earlier, mutual fund houses used their discretion to qualify stocks as small-cap stocks. It wasn’t mandatory for them to invest 65% of their assets in small cap companies. Mutual funds had the flexibility to switch to larger companies, in case the markets fell or small caps became overvalued.
After SEBI’s categorisation norms coming into effect, small-cap mutual funds have specifically characterised. And to align with new regulatory requirements, many mutual funds have exited small-sized companies. A number of midcap funds that invested in smaller companies had to sell off many of their portfolio holdings, which possibly resulted in small-cap carnage.
Many small-cap oriented schemes have underperformed even the S&P BSE Small-Cap TRI (Total Return Index) over last three years. Their recent performance, too, isn’t exciting either.
What can you expect going forward from small-cap mutual funds?
(Image source: flickr.com)
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Small-cap funds have the tendency to go from thrilling highs to dangerous lows. Plus, small-cap stocks, due to their size, usually have a low trading volume. Thus, note that the risk associated with small-cap funds is greater than mid-cap funds.
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At present, the valuations in the small-cap space are incredibly high, and earnings growth isn’t keeping pace with them. Therefore, despite the massive fall in small caps recently, they still look overvalued.
On this backdrop, investing in small-cap mutual funds has become even riskier.
[Read: Wish To Invest In Small Cap Mutual Funds? Read This!]
What should you do?
Unless you have a very high-risk appetite, you should avoid investing large sums in small-cap oriented mutual funds. But that doesn’t mean, you should avoid them totally.
If you are looking to boost your long-term returns where your investment time horizon is over 10 years, you may consider investing some portion in a small-cap fund/s. However, you should strategically structure and restructure your portfolio based on a “core and satellite” strategy of investing.
This strategy aims to get the best of both worlds, that is, short-term high-rewarding opportunities and long-term steady-return investing …and the good thing is, it works!
The term “core” applies to the more stable, long-term holdings of the portfolio; while the term “satellite” applies to the strategic portion that would help push up the overall returns of the portfolio, across market conditions.
PersonalFN’s research states that 60% of the portfolio shall be reserved for Core mutual funds and the rest 40% for the Satellite mutual funds.
Your ‘core portfolio’ should consist of large-cap, multi-cap, and value style funds. The ‘satellite portfolio’ should include funds from the mid-and-small cap category and opportunities style funds. And you should invest in via Systematic Investment Plans (SIPs), a mode of investing in mutual funds to mitigate market volatility.
Below are the benefits of following the core and satellite approach:
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Facilitates optimal diversification;
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Reduces the need for constant churning;
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Aims to create wealth, cushioning the downside;
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Reduces the risk to your portfolio;
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Enables you to benefit from a variety of investment strategies; and
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Offers the potential to outperform the market
The ‘Core and satellite’ investing is a time-tested strategy followed by some of the most successful investors.
But what’s critical is the art of astutely structuring the portfolio by assigning weights to each category of mutual funds and the schemes picked for the portfolio. Moreover, with changes in market outlook, the allocation/weight to each of the schemes, especially in the satellite portfolio, needs to change.
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