Small-cap mutual funds have seen increasing investor allocation in recent years as investors look beyond large-cap and flexi-cap funds and assess both past returns and future growth potential. However, experts caution that small-cap investments can carry higher volatility and require investors to have a long-term horizon, discipline and appropriate asset allocation.
In a conversation on Zee Business, mutual fund experts Vishwajeet Parashar and Hemant Rustagi explained the risks and potential of small-cap investments. They highlighted five key factors investors should consider: volatility and drawdowns, liquidity, valuations, investment horizon and portfolio allocation.
1) Higher volatility and sharper drawdowns
Small-cap funds can witness sharper falls during market corrections compared with larger companies. According to mutual fund expert Vishwajeet Parashar, small caps are generally considered a “high risk, high returns” segment because their drawdowns can be higher.
“Small caps generally are called high risk, high returns because when drawdowns come in small caps, the drawdowns are more,” Parashar said.
He also noted that the risk profile of the segment has improved compared with the past. According to him, the smallest companies in the small-cap universe have become significantly larger than they were earlier. He cited the change in the market-cap cutoff, saying the smallest stock in the small-cap category was around Rs 5,000 crore in March 2022, compared with around Rs 12,000 crore currently.
However, he cautioned that this does not mean the risk has disappeared. Small caps can still fall more during market corrections.
Parashar advised investors to remain patient and disciplined and avoid stopping their SIPs in panic when markets correct.
2) Liquidity risk during market corrections
Liquidity is another important factor investors should examine before investing in small-cap funds. The risk becomes more relevant when a market correction leads to increased redemptions.
“Liquidity risk happens when there is a correction and investors start redeeming,” Parashar said.
He explained that fund houses may keep some cash and may initially sell more liquid stocks when redemption pressure rises. If the pressure increases further, fund managers may have to sell less-liquid stocks as well, which can affect the fund’s NAV.
Parashar advised investors to check the stress-test disclosures of small-cap funds before investing. These disclosures provide information on how long a fund house could take to liquidate 25 per cent or 50 per cent of its portfolio.
He said investors should not select a small-cap fund only on the basis of its previous year’s returns and should also examine the fund’s liquidity position.
3) Valuation risk
Small-cap valuations can become expensive when significant amounts of money flow into the segment. However, Hemant Rustagi said investors should assess valuations along with the earnings growth of the companies.
He explained that small-cap companies are generally growth-oriented businesses and that strong earnings growth can make higher valuations more reasonable.
“High-growth companies will never be available cheaply,” Rustagi said.
According to Rustagi, if earnings growth is around 30–35 per cent or higher, investors should understand that high-growth companies are unlikely to trade at low valuations. Therefore, higher valuations should be assessed in the context of the company’s earnings growth.
Rustagi said that, at this stage, he did not see a major valuation concern in the segment if earnings growth continues to justify the valuations.
4) Short investment horizon can increase the risk
Small-cap funds require patience because investors may have to go through periods of volatility and market corrections.
Parashar specifically advised investors to consider a seven-year or longer investment horizon before investing in small caps.
“If you have a seven-year time horizon, only then invest in it,” he said.
He explained that a longer investment horizon can help investors manage the impact of short-term volatility and allows them to remain invested through market cycles.
The experts also stressed that investors should have clarity about their financial goals and understand how long their money can remain invested. A longer horizon gives investors greater ability to tolerate volatility.
For disciplined SIP investors, volatility can also provide an opportunity to average investments across market cycles. However, the experts stressed that this approach requires patience and a long investment horizon.
5) Over-allocation can make the portfolio too aggressive
While small caps can offer higher growth potential, investors should consider their overall asset allocation before increasing exposure to the segment.
Rustagi said the appropriate allocation depends on an investor’s personal situation, risk-taking capacity and investment horizon.
As an illustration, he suggested an allocation of 40 per cent to large caps, 35 per cent to mid caps and 25 per cent to small caps. The allocation, however, is not meant to be a one-size-fits-all formula and should depend on the investor’s individual circumstances.
The experts also cautioned against making the portfolio unnecessarily aggressive by adding more small-cap exposure.
In response to a portfolio-related question, Rustagi said that adding another small-cap fund to an existing small-cap allocation could make the portfolio “considerably more aggressive.”
Therefore, investors should evaluate their overall equity portfolio and asset allocation rather than looking at a small-cap fund in isolation.
Why are investors increasing allocation to small caps?
The experts said the rise in small-cap allocation is linked not only to past returns but also to investors’ increasing focus on long-term financial goals and future growth potential.
The experts highlighted sectors such as electronics manufacturing services (EMS), capital-market companies and power-equipment businesses, where several companies fall within the mid and small-cap segments.
The experts also noted that investors are looking at the future potential of such companies along with their returns.
At the same time, the increase in small-cap allocation was not described as alarming. Small caps account for around 11.5 per cent of total equity AUM, compared with around 13.5 per cent for mid caps.
The trend was described as healthy, provided investors maintain proper asset allocation and have the required investment horizon and discipline.
Who should consider small-cap funds?
According to the experts, investors who have a long investment horizon, adequate risk capacity and the discipline to remain invested during periods of volatility can consider small-cap funds.
Rustagi said that investors following a proper asset-allocation process and having a long-term horizon can have small-cap exposure in their portfolios.
The amount allocated to small caps, however, should depend on the investor’s personal circumstances, risk-taking capacity and investment horizon.
Key takeaway for investors
Small-cap funds can provide exposure to high-growth companies, but investors should not choose them solely on the basis of past returns. The segment can experience sharper drawdowns and higher volatility, while liquidity can become a concern during periods of heavy redemptions.
At the same time, higher valuations do not automatically make small caps unattractive if earnings growth continues to justify those valuations.
For investors considering an SIP in small-cap funds, the experts’ message is to maintain a long investment horizon, follow proper asset allocation, remain disciplined during market corrections and avoid excessive small-cap exposure.
For disciplined investors with the appropriate time horizon and risk capacity, volatility can also provide an opportunity to average investments across market cycles.
