Small-cap funds: Existing investors should rebalance, continue SIPs

New investors planning large lump-sum investments should stagger them over 6-12 months

Investors have pulled Rs 3,607 crore out of large-cap funds while pouring Rs 26,305 crore into smallcap funds in 2023.

The primary driver behind these flows is returns. While largecap funds have given a return of 11.97 per cent year-to-date (YTD), smallcap funds have given 26.38 per cent. The question is, should investors allocate large sums to a more volatile category while pulling out money from their more stable counterparts?

High earnings growth expectations

The smallcap indices had given negative returns in 2022.

“Valuations had become depressed. As earnings caught up, a rally commenced,” says Vidya Bala, co-founder, Primeinvestor.

The smallcap segment tends to outperform during an equity market upcycle.

“During the upcycle of 2003 to 2007, small caps were up 16 times whereas large caps were up six times. Between 2020 and now, small caps are up 4.2 times whereas large caps are up 2.5 times,” says Arun Kumar, head of research, FundsIndia.com.

Earnings growth is expected to be strong.

“According to the Bloomberg consensus estimate, earnings of the small-cap index are expected to grow by 20 per cent annually over the next two years,” adds Kumar.

Capacity for wealth creation

Smallcap funds have the ability to create significant wealth over the long term.

“Investors get exposure to upcoming companies with a significant growth runway. As they grow, their stock prices see considerable appreciation,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor.

The smallcap investing style has proved its mettle across the world. “Over a 10 to 15-year horizon, small caps tend to outperform large caps.”

Investors cannot do without exposure to the small (and mid) cap segment if they desire high growth. 

“Over 60 per cent of the Nifty 50 index is made up of financials, information technology, and fast-moving consumer goods companies. Given their already large size, companies in these sectors can’t grow at a rate far exceeding the nominal GDP. Hence, investors need to look beyond the top 100 stocks.”

Many upcoming opportunities—China plus one, import substitution in electronics, discretionary consumption, and so on—can only be capitalised upon by venturing beyond large caps.

“Speciality chemicals or contract manufacturing stocks all lie outside the top 100,” says Bala.

Can you tolerate the volatility?  

Investors contemplating large investments in the small-cap space should take cognisance of its risks. 

Says Belapurkar: “Many players are new. They have not been tried and tested. The mortality rate tends to be high.”

Investors need to be prepared for frequent and steep declines. Says Kumar: “In nine out of the past 18 years, the Nifty Smallcap 250 saw a temporary, intra-year decline of above 20 per cent. By contrast, the Nifty 50 witnessed falls of more than 20 per cent in only five years. Furthermore, the average fall in the Nifty 50 was 18 per cent compared to 25 per cent in Nifty Small Cap 250.”

Every 7-10 years the large-cap segment witnesses a mega fall of, say, 50 per cent. In those years, the small-cap universe could decline by 60-70 per cent. “Whenever there is a fall of 20 per cent or so, investors get worried that this could be the start of a mega fall. This triggers an exit from the segment,” says Kumar.

What should you do?

Investors holding smallcap funds, whose goals are far away, should stay invested.

Says Bala: “They should continue with their systematic investment plans (SIP). A correction, if it happens, will only help average out the purchase price of units.”  

Belapurkar suggests that if an investor’s goal is only a couple of years away, and her allocation to the segment has got stretched (say, from 15 to 20 per cent of the equity portfolio), she should rebalance.

New investors should first build their core portfolio using large-cap and flexi-cap funds, and then venture into mid-and small-cap funds with a minimum horizon of 7-10 years.

Their allocation to this segment should not exceed 15-20 per cent of the equity portfolio. Those planning lump sum investments should stagger them over 6-12 months.