Small-cap funds make comeback, but they are a volatile investment option

Only investors with appetite to handle their high volatility should enter them

After disappointing investors in 2018 and 2019, small-cap funds have made a strong comeback. They appear set to outperform both large- and mid-cap funds this calendar year.

What is driving the bounce-back? 

The category is catching up after a long spell of price and time correction since January 2018. 

Also, the economy is improving and liquidity flows into the market have been strong.  “The small-cap segment tends to do well in such an environment," says Ashwin Patni, head-products and alternatives, Axis Asset Management Company. 

Fund managers say the quality of management at many small-cap firms has improved after demonetisation and the introduction of GST. 

“Many promoters have realised that the best way to create wealth is by enhancing the market capitalisation (m-cap) of their companies. The interests of promoters and investors are better aligned today," says Samir Rachh, fund manager, Nippon India Mutual Fund. 

High growth potential

Barring the top 250 by m-cap, the rest of the listed stocks are all small-caps. "This is a large universe in which investors can get exposure to upcoming or emerging businesses," says Rachh. 

Small-cap funds often don't move in tandem with large-caps. "Having these funds can make your portfolio more diversified," says Harsh Jain, co-founder and chief operating officer, Groww.

A more volatile segment

This is the more volatile and risky segment of the market. "Smaller companies' ability to deal with adverse economic conditions tends to be lower than that of larger peers," says Patni. 

The small-cap segment also tends to be less liquid, which means inflows and outflows of smaller amounts can cause large gyrations in their stock prices.

Dispersion in the performance of companies belonging to the same sector tends to be higher within the small-cap segment. This, combined with the paucity of information about companies and management, makes stock-picking harder here. 

What should you do? 

To cope with the higher volatility of these funds, take limited exposure to them. Small-caps constitute 15 per cent of the overall m-cap. You may take exposure of a similar level in your equity portfolio. If you are new to the markets, limit exposure to 5-7 per cent. A longer investment horizon can also help deal with volatility. "Only invest money you won't need for 10 years or more," says Jain. 

Average out your entry cost by taking the SIP/STP route.

The performance of these funds tends to be cyclical. Investors may be tempted to think they will be able to time their entry and exit. "This is difficult to pull off as greed or fear gets the better of most investors,” says Prateek Mehta, co-founder and chief business officer, Scripbox. 

Either have a long investment horizon or follow a strict asset allocation approach, which means book profits when you become overweight on this segment, and invest more when it is not doing well. 

Finally, select a fund manager focused on picking companies that have the potential to grow over the long term.