Investors should limit their allocation to smallcap funds at 15-20%

Book profit if you have become overweight after the recent run-up

Small caps have been the most vibrant segment of the Indian stock market for some time now.

Currently, new fund offers of Motilal Oswal Small Cap Fund and DSP Nifty Smallcap250 Quality50 Index Fund are open for subscription.

Twenty-six smallcap schemes managed assets worth Rs 2.2 lakh crore on November 30.

“There is strong earnings growth momentum in smallcap stocks. Multiple factors such as healthier balance sheets, rising weight of smallcaps in the market, strong earnings momentum and resultant reasonable valuations could be beneficial to the next wave of smallcap investors,” says Akhil Chaturvedi, chief business officer, Motilal Oswal Asset Management Company (AMC).

The smallcap lure

Smallcap schemes allocate at least 65 per cent of their money to smallcap stocks, which include all companies ranked 251st onwards in terms of market capitalisation. Until November 30, 2023, smallcap schemes had witnessed net inflows of Rs 37,178 crore.  

Over the past three years, they have given 33.1 per cent average annualised return, the highest among all diversified-equity categories.

“Strong liquidity, several tailwinds, and broader market participation are factors that have helped smallcaps perform better,” says Ravi Kumar TV, founder, Gaining Ground Investment.

The MF route

Many investors have been investing directly in smallcap stocks. When the going is good, portfolio values rise.

However, identifying the right stocks is a tough task in the smallcap space, which is under-researched.  

“The underlying businesses (of smallcap stocks) may have fewer investors and lower liquidity as compared to the large and midcap segments. This may create volatility whenever a large investor enters or exits, leading to higher volatility at the portfolio level,” says Sirshendu Basu, head-products, Bandhan Asset Management Company (AMC).

Mutual funds offer diversified portfolios of smallcap stocks, thereby reducing concentration risk.

Stocks picked carefully based on growth visibility, reasonable valuations, sound management and relatively strong balance sheets can reduce the volatility associated with smallcap portfolios.

Selecting a smallcap fund

While selecting a smallcap scheme, go with one that has a good track record and a stable fund manager.

“Select a scheme having a quality fund manager, and a fund house known to have an experienced fund management and research team,” says Ravi Kumar.

Also, be mindful of liquidity risk. Smallcap schemes investing most of their money in illiquid names could be highly risky.

“Our research shows that profitability and improvement in free float can alleviate volatility and liquidity-related concerns,” says Chaturvedi.

Active or passive choice

While picking an actively managed fund with a good track record is the more commonly pursued path in this segment, investors keen to avoid fund manager risk may also consider index funds tracking indices such as the Nifty SmallCap250 or the Nifty SmallCap50.

“While active funds attract most of the attention, there’s rising interest in passive smallcap funds. Despite their modest assets under management (Rs 2,200 crore as of November 30, 2023), passive smallcap funds offer a solution to a significant challenge do-it-yourself investors face — simplifying investment decisions. Smallcap index funds are also cost-effective,” says Basu.

Only for risk-takers

Smallcap funds are suitable only for investors with a high-risk appetite. Invest in this segment only if you have a long investment horizon of seven years or more and can withstand high volatility.

“Investors who are looking for opportunities in niche or unique segments and for the possible large caps of tomorrow may consider this category,” says Basu.

According to Chaturvedi, systematic investment plans (SIPs) should be the default choice for putting money in small-cap funds.

Before investing, check your current smallcap allocation. Many multicap and flexicap schemes also allocate money to smallcap stocks. Invest in these schemes only if you are under-allocated.

“Depending on the investment horizon, one may allocate up to 20 per cent to smallcap funds in one’s equity portfolio,” says Ravi Kumar.

If after the current run-up you have become overweight on this segment, book profits.