Small-Cap Funds An Attractive Option

The Indian stock market, after being in a very narrow range and consolidating for the last few quarters, has witnessed the first signs of breaking away from the range over the last couple of months. Frontline indices such as Nifty and Sensex are up by almost 8 per cent from the start of the financial year. Nevertheless, Small-Cap stocks, which are often overshadowed by their larger and more prominent counterparts, have seen better a performance in the same period. Since the start of April 2023 we have witnessed the small-cap index outperforming both the Mid-Cap and Large-Cap indices.[EasyDNNnews:PaidContentStart]



 

Performance of Small-Cap Funds

The impact of the performance of the small-cap stocks is clearly visible in the performance of funds dedicated to this cap. The small-cap-dedicated funds too outperformed the other categories. With a return of 6 per cent, small-cap funds have outperformed other categories, including large-cap, large-cap and mid-cap as well as sectoral banking funds. Small-cap funds have emerged as the top-performing category with a significant one-month return of 6 per cent. This outpaces the returns of other popular categories such as large-cap (4.86 per cent), large and mid-cap (4.82 per cent) and sectoral banking (5.07 per cent).

There are a couple of funds that have even generated lower double-digit returns year in the same period. This exceptional performance indicates the ability of small-cap funds to generate attractive returns in a relatively short period of time when the market starts turning around. Despite a significant drop in the small-cap index over the last few months, investors remain optimistic about the small-cap fund category. This is evident from the fact that small-cap funds have seen net inflows of over ₹2,200 crore per month over the past few months. In fact, in January, small-cap funds saw inflows of ₹2,255 crore among the 11 categories of equity funds.

Notably, small-cap funds emerged as the highest receiving category among equity funds in January. The story continued for later months also. Retail investors are increasingly favouring mutual funds in the small-cap segment, leading to significant inflows. According to data from the Association of Mutual Funds in India, small-cap funds recorded the highest inflows among all equity categories even in March (₹2,430 crore) and April (₹2,182 crore) this year. Riskier MF products like small-cap have consistently outperformed other categories in terms of monthly net inflows since October 2022.

From October to April, small-cap and sectoral funds collectively received over ₹12,000 crore in net investments, while flexi-cap and large-cap funds attracted ₹3,900 crore and ₹1,100 crore, respectively. Investors’ growing interest in the small-cap category is being driven by a number of factors, including:

1. A large number of retail investors are currently avoiding the direct route and instead opting for mutual funds. This is because mutual funds offer a number of advantages such as diversification and professional management.

2. Small-cap funds have consistently outperformed large-cap funds over the past decade. This is due to the fact that small-cap companies tend to grow faster than large-cap companies.

3. The Indian economy is expected to grow at a healthy pace in the coming years. This will create opportunities for small-cap companies to grow.
 

Timing the Investment in Small-Caps

After undergoing a significant correction both in terms of time as well as valuation from its peak in October 2021, the valuation premium of Indian equities in relation to other emerging markets has diminished. The 12-month forward price-to-equity (PE) ratio of the Morgan Stanley Capital International (MSCI) India index currently stands at approximately little more than 19 times, a notable decrease from its historical peak. Furthermore, the market capitalisation to GDP ratio in India – commonly referred to as the Buffett indicator after renowned investor Warren Buffett – currently sits at 90 per cent as of May 25, 2023, compared to 119 per cent during October 2021.

This suggests that Indian equities are now considered fairly valued and have good room to rise. In terms of the trailing PE ratio, the Nifty Small-Cap 250 index currently stands at around 18.8 times, representing a decline from its peak during the pandemic period. The PE during October 2021 was at 31 times. Similarly, the 12-month forward PE ratio of the MSCI India Small-Cap index is approximately 19.2 times, also showing a decrease from its historical peak. All this shows that valuations of the small-cap stocks have moderated and there are chances that we may see a continuation of the same momentum. This will directly benefit the small-cap funds too. 

Investment Riders for Small-Caps

There is no doubt that small-cap funds are offering a good margin of safety now. However, before investing in these funds there are certain points you need to take care of. It is crucial to approach small-cap mutual funds with caution, taking into account various quantitative and qualitative parameters to ensure a rewarding investment experience. Relying solely on past returns is not advisable as they do not guarantee future performance. Small-cap funds have shown more volatility compared to mid-cap and small-cap-dedicated stocks. Besides, they have larger drawdowns.

Since small-cap funds invest a majority of the corpus in small-cap stocks, we will take the small-cap index as proxy to small-cap funds and will try to explain the risks associated with investment in small-cap funds. Taking data from year 2005, we observed that on an average the small-cap index has witnessed average drawdown of 23 per cent while the mid-cap and large-cap indices have much lower average drawdowns. The table and graph alongside clearly show the risk associated with investing in small-cap stocks.

Therefore, investors should exercise careful consideration and conduct thorough research before investing in small-cap mutual funds, taking into account both historical performance and other relevant factors to make informed investment decisions.
 

Factors to Note

When planning your investments through mutual funds, there are four crucial factors that you need to consider. These factors include your investment goal, time horizon, risk appetite and the amount you can commit. Understanding and evaluating these elements will play a significant role in guiding your investment decisions.

1. Investment Goal — Clearly define your investment goal. Whether it’s saving for your child’s education or upgrading your vehicle, your investment goal will shape your investment strategy. For unavoidable expenses with a lower risk appetite, broader market-dedicated funds may not be suitable. However, if you are willing to take on more risk for a discretionary expense, a riskier investment may be appropriate.
 2. Time Horizon — The length of time you are willing to invest is an essential consideration. Investing in broader market-dedicated funds typically requires a longer time horizon. If your investment horizon is between five and ten years, you can consider large-cap and mid-cap funds. For time horizons exceeding 10 years, you have the option to choose mid-cap or small-cap funds, or even a combination of both, based on your risk appetite and investment goal.
3. Risk Appetite — Assess your risk appetite and tolerance. If you have a high risk appetite, small-cap funds can be a suitable choice. However, if you prefer a more moderate level of risk, mid-cap funds may be better suited for your investment needs. It’s essential to align your risk tolerance with the investment instrument to ensure a comfortable investment experience.
4. Investment Amount — Consider the amount of money you can commit to your investment. This will determine the type of mutual funds you can invest in and the level of diversification you can achieve. It’s crucial to invest an amount that aligns with your financial capabilities and does not strain your overall financial situation. By carefully evaluating these four factors, you can make informed decisions when planning your mutual fund investments. Remember, it’s important to regularly review and reassess your investment portfolio to ensure it remains aligned with your changing goals and circumstances.

What are Small-Cap Funds?

The Securities and Exchange Board of India (SEBI) has very clearly defined three market capitalisation segments and stocks:

∎ Large-Cap — Stocks ranked 1-100 by market capitalisation
∎ Mid-Cap — Stocks ranked 101-250 by market capitalisation
∎ Small-Cap — Stocks ranked 251 onwards by market capitalisation. Small-cap funds should have at least 65 per cent investment in small-cap stocks.

The Right Approach

One of the best ways to invest in such funds is through a systematic investment plan (SIP). This is because investment through this route helps you to manage volatility better than lump sum investment. Since small-cap funds tend to show more volatility and drawdown than the large-cap funds it makes sense to invest in these funds through SIP. If you are investing for a long term the downturn in between actually helps you to gain more as you tend to accumulate more units when the market is down. A case in point is the last 18 months when the small-cap funds experienced a drawdown. This would have helped investors to accumulate more units at a lower price. 

There is very minimal difference in returns if you try to time the market based on the frontline index level. Consider for example an investment process that you had started in January 2013 with ₹5,000 in Franklin India Smaller Companies Fund Growth. In January 2020, sensing that frontline indices were trading at a lifetime high, you stopped your SIP and exited your investment. The XIRR returns would have been 10.85 per cent.

Nonetheless, if you would have been patient and remained invested throughout the phase of downturn and subsequent upside, the return would have been much better.

One of the reasons higher levels of indices should not perturb you and force you to remain on the sidelines is that this may cost you dear. According to a research by Morningstar, between March 2011 and February 2021, Indian stocks owed their outperformance over cash to just eight months—less than 6.7 per cent of the months in the sample. If you had held stocks for all the 112 months apart from those eight critical months when the equity market gave extraordinary returns, your investment would not have beaten even cash. The obvious implication of these findings is that it is exceedingly hazardous to try to time markets. Staying invested is the name of the game, be it in equities as an asset class or the funds you select to invest in. The report further says that less than 5 per cent of the months account for all of the outperformance of the Indian actively managed diversified equity funds. Therefore, it makes sense to remain invested.
 

Conclusion

Amidst the vast sea of investment opportunities, there exists a realm of untapped potential where hidden gems lie in wait. Small-cap funds, a dynamic segment per se, can help you to exploit this opportunity. These funds, focusing on companies with smaller market capitalisations, have the power to deliver impressive returns and fuel portfolios with growth. In today’s ever-evolving financial landscape, where traditional investment avenues face increasing challenges, small-cap funds offer a compelling alternative. Small-cap funds should generally be considered long-term investments. If you have a long investment horizon, the timing of your entry into the market becomes less critical. Over the long term, small-cap funds have the potential to deliver substantial returns, provided you can weather short-term market fluctuations. Besides, what is also important while investing in small cap funds is the factor of diversification. Small-cap funds should be part of a welldiversified investment portfolio. This approach allows you to benefit from potential growth opportunities while managing risk through diversification.

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