Select small-cap fund manager with proven expertise in this segment

As a result, small-cap funds have garnered the maximum inflows among all equity categories in March (Rs 2,430 crore) and April (Rs 2,182 crore) 2023, according to data from the AMFI

A large number of retail investors are currently avoiding the direct route and instead opting for mutual funds in the mid-cap and small-cap segment. As a result, small-cap funds have garnered the maximum inflows among all equity categories in March (Rs 2,430 crore) and April (Rs 2,182 crore) 2023, according to data from the Association of Mutual Funds in India.

Optimism driven by positive experience
 

Investors are displaying high interest in the small-cap category because of their positive experience. “Over the past decade, small-cap funds have consistently outperformed large-cap funds,” says Resham Jain, fund manager, DSP Mutual Fund. Jain also points out that the majority of active funds in this category have beaten their benchmarks.
 

The market correction since December 2022 has caused many small-cap stocks to correct sharply. “Investors seem to believe the correction has provided them with a good long-term entry point,” says Samir Rachh, fund manager, equity, Nippon India Mutual Fund.
 

Large opportunity size
 

All stocks ranked below 151 in market capitalisation are small-cap, so fund managers have a large universe to choose from.

The small-cap segment offers a wide range of sectors and sub-sectors with rapidly growing industries that are not accessible through the mid-cap and large-cap categories. “Many of these small-cap companies have established themselves as leaders in their respective fields, both domestically and globally. As the Indian economy keeps growing, they could gain scale and become competitive at the global level,” says Jain. She cites the example of the chemicals sector, where several small-cap companies have successfully made the transition to mid-cap or large-cap status over the past decade.
 

With the worst of the high inflation and rising interest-rate cycle behind us, the economy may pick up pace. “If this hypothesis proves correct, there will be a lot of opportunities for picking up individual stocks. Valuations within the small-cap category are neither too cheap nor too expensive. If earnings come back, one can hope to make returns equal to earnings, even assuming no PE (price to earnings) re-rating,” says Rachh.
 

Longer runway for growth
 

The small-cap universe is under-researched, due to which fund managers have a higher probability of discovering mispriced stocks. The small size of these companies also gives them a longer runway for growth. “Their ability to reinvest their limited cash flows into the business at higher return on equity (ROE) enables them to achieve faster growth compared to larger companies,” says Jain.
 

Beware high volatility
 

Small-cap stocks can be very volatile in the short term. “Since these companies lack balance sheet strength, they get affected the most whenever the macroeconomic environment turns adverse,” says Nirav Karkera, head of research, Fisdom. The concentrated nature of these businesses also makes them susceptible.
 

Analyst coverage drops sharply beyond the top 1,000 stocks. “It is possible to make mistakes in stock selection due to inadequate knowledge of a company’s corporate governance standards, credibility of its financial numbers, etc,” says Gopal Kavalireddi, head of research, FYERS.
 

Take limited exposure
 

Exposure to this volatile category should not exceed 10-15 per cent of the equity portfolio. “Investments in these funds should be through the SIP or STP (systematic transfer plan) route ,” says Karkera. Investors should only enter this segment if they have a five- to seven-year horizon.
 

Fund manager’s role is pivotal 
 

The performance of small-cap funds is highly dependent on the stock picking skills of the fund manager. “The fund manager must have expertise in the small-cap domain and should be backed by a strong in-house research team,” says Karkera.

Besides performance in rising markets, investors should also check the fund manager’s ability to contain downside risk. Kavalireddi warns against investing in either very small or very large sized funds, and those with very high expense ratios.