Is it the right time to invest in small-cap funds?

The quick bounce after the March crash must be seen in the larger context, say experts. Small-cap funds severely underperformed their large-cap counterparts in CY 2018 and 2019. These funds lost 18.62 per cent and 1.51 per cent in those years, respectively. Large cap funds delivered 1.1 per cent and 10.53 per cent returns, respectively, in those years. “Many small-cap companies reported lower-than-expected earnings over these two years and the valuations also came down severely,” says Nimesh Chandan, Head- Equity Investments, Canara Robeco AMC. Investors’ expectations from small-sized firms were low. “Some small-cap firms delivered well even during such volatile times, which made them attractive investments after the crash in March,” he adds.

From April, when equity markets started to recover, some smart investors saw the opportunity in beaten-down stocks. They weren’t the only ones. “Many new investors started with investing in shares of small-sized companies. Hence, these shares have posted a smart recovery,” says Deepak Chhabria, founder director and CEO of Axiom Financial Services.

Investment opportunities exist, but there may be landmines

After SEBI reclassified stocks based on their market capitalisation in 2018, all stocks from the 251^st in terms of market capitalisation are classified as small-cap firms. “Many structural reforms in the last five years have made many small-cap companies clean up their books and emerge more compliant. Such good-quality companies spread across sectors offer a wide choice for investors,” says Samir Rachh, Fund Manager, Nippon India Mutual Fund.

Chandan believes that a “carefully crafted portfolio of small-cap companies chosen on the basis of high corporate governance standards, efficient use of capital can create wealth for patient investors.”

But with such a wide list to pick and choose from, advisors say that fund managers ought to be cautious. “Balance sheets of many small-cap companies are not robust. Many of them will find it difficult to sustain if the economy takes longer-than-expected to recover,” says Chhabria. He advises against investing in a small-cap fund when markets are close to their highs.

Rachh says that small-cap valuations have run ahead of fundamentals. A small correction at this juncture cannot be ruled out and investors can use it as an entry point.

Though small-cap funds could deliver well, investors cannot ignore the intermittent volatility. Downward moves can be quick and ferocious.

Scheme choices matter

Most small cap schemes run diversified portfolios with more than 50 stocks to overcome challenges such as liquidity and concentration risks. As the SEBI regulation mandates 65 per cent investments in small cap stocks, some allocation is made to liquid names in the mid-cap space too.

Among large schemes, HDFC Small Cap Fund, with the highest asset under management of Rs 8645 crore, has the lowest portfolio turnover ratio of 7.74 per cent. It had 72 stocks in the portfolio as on August 31, 2020. Nippon India Small Cap Fund, with a size of Rs 8322 crore has 51 per cent turnover and 112 stocks in the portfolio, as on July 31, 2020.

While most of them are more or less invested in stocks, both Axis Small Cap and Tata Small cap hold 12.5 per cent in debt investments as on August 31, 2020.

Schemes with large assets under management are difficult to manage as the fund managers have to walk on the tight rope of pocketing returns and managing liquidity simultaneously.

Should you invest?

Investors tend to chase an asset class that has done well in the recent past. “Do not invest in small cap funds because they outperformed large and mid-cap schemes over last the last 3-4 months,” says Rupesh Bhansali, Head of Mutual Funds, GEPL Capital. He recommends investing in these schemes only if you are a long term investor.

You can consider investing in these schemes to the tune of up to 10-15 per cent of your equity portfolio, provided you have adequate appetite to stomach risks. Invest through a systematic investment plan (SIP).

Traditionally, these schemes have rewarded investors for the risks they took. However, as mentioned above, these schemes’ portfolios have undergone significant changes over the last few years. Also,  low rate interest rates indicate low growth expectations. “In a low interest rate environment, investors need to moderate their returns expectations. Small-cap funds can deliver 200 to 300 bps higher CAGR returns than their large cap counterparts,” says Rachh.