Unlocking the Potential of Smallcaps through Index Investing

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In the bustling landscape of Indian economy, optimism abounds as the nation marches towards its ambitious goal of becoming a $5 trillion economy by 2028. Central to this vision are the thriving SMEs and small-scale industries, poised to play a pivotal role in fueling both domestic and international growth. But what does this mean for investors?

Small-cap investing offers an enticing prospect of rapid expansion and robust growth, outstripping the trajectories of many mid and large-cap counterparts. As the economic landscape broadens, so does the market potential for various industries, propelling the growth of small-cap companies.

These enterprises, with their nimble size and agility, excel in seizing emerging opportunities, consolidating market share, and capitalizing on government incentives such as tax breaks.

The remarkable rally witnessed in the small-cap space over the past year underscores the inherent dynamism and promise of these enterprises.

Over the last decade, small-cap stocks have demonstrated their potential for substantial growth. In fact, 85.18% stocks that went 10X in 10 Years were smallcaps.

Notably, in January, small-cap funds emerged as the top-performing category, attracting flows of Rs 2,255 crore, surpassing all other equity fund categories. The recent surge in small-cap funds further reflects investor confidence, with consistent net inflows exceeding Rs 2,200 crore per month in the past two months.

However, it's essential to acknowledge the inherent risks accompanying these investments. Small caps are notorious for their volatility and susceptibility to market fluctuations, making them inherently riskier. Consequently, building a diversified portfolio of small-cap stocks becomes imperative for investors venturing into this segment.

But how does one achieve diversification in small-cap investing? This is where small-cap indices come into play. The Nifty Small Cap 250 Index, for instance, comprises 250 companies spanning 21 sectors, offering investors exposure to a broad array of small-cap stocks across various industries. Diversification across this spectrum mitigates the risk associated with individual stock selection, significantly reducing the potential downside.

When contemplating investments in small-cap stocks, investors typically have three avenues to explore.

The first option involves directly purchasing individual small-cap stocks, a strategy fraught with challenges given the segment's volatility and the difficulty in identifying potential winners.

Alternatively, investors may opt for actively managed small-cap funds, each with its investment approach and varying performance outcomes.

However, the third option, investing in a small-cap index fund, is increasingly gaining traction for its passive management approach and diversified exposure to the small-cap segment.

By mirroring the Nifty Small Cap 250 Index, investors benefit from broad diversification across sectors, minimizing the risk of individual stock selection while ensuring participation in potential high performers within the small-cap universe.

Examining the historical performance, over a 10-year period, the Nifty Small Cap Index has given CAGR returns of 18.90% that as against 12.96% CAGR returns  delivered by the Nifty 50 Index. For example, a ₹15,200 monthly SIP in the index fund would have grown to over ₹1 crore in 15 years.

Moreover, the current valuation of the index presents an attractive proposition for investors.

The PE ratio of the index is currently 25.62 which is below it’s 5 year average.  Active funds in the small cap category have a PE ratio of 42.62.(Ace Equity, Internal Research by Groww Mutual fund). Hence the index is priced favourably as compared to active funds and hence we feel this may be one of the good options for investors.

Recently, Groww Mutual Fund announced the launch of the Groww Nifty Smallcap 250 Index Fund, an open-ended scheme replicating/tracking the Nifty Smallcap 250 Index-TRI.

The scheme opened for public subscription on February 09, 2024, and will close on February 23, 2024. The scheme re-opens for ongoing subscription and redemption within five business days from the date of allotment of units.

In essence, small-cap index investing offers a compelling avenue for investors to harness the growth potential of small-cap stocks while mitigating the associated risks through diversification and passive management.

As the investment landscape continues to evolve, embracing strategies that combine growth opportunities with risk mitigation becomes increasingly vital for investors looking to build robust and resilient portfolios for the future.

Moneycontrol journalists were not involved in the creation of the article.