Base effect contributing to small-cap funds' 30% return over three years

Limit exposure to this volatile category to 10-15% of equity portfolio, enter with 7-10-year horizon

Small-cap funds have given a category average return of 30 per cent over the past three years, which makes them among the best performing categories over this horizon. Over the past year, however, this category’s  return has been muted at 3 per cent.

Base effect

A couple of factors have contributed to the category’s strong performance over the three-year period.  

“Sectors like chemicals, engineering, garments, etc have done well over this period and they belong mostly to the small-cap segment,” says Samir Rachh, fund manager-equity, Nippon India Mutual Fund, who manages the largest fund in this category (the Rs 22,844 crore Nippon India Small Cap Fund).  

The base effect has also contributed. “Small-cap funds performed poorly in 2018 and 2019. Then these funds had two strong years in 2020 and 2021, which is why their returns appear very strong over a three-year period,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser.

Flows have also been strong. “There has been a good amount of inflow into the small cap segment in mutual funds. HNIs and retail investors are participating in larger numbers. The proliferation of portfolio management services (PMS) and alternative investment funds (AIFs) has also played a part,” says Rachh.

Long-term wealth generator  

Most retail investors should have some allocation to these funds. “Small-cap funds have the potential to create wealth and generate sizeable alpha over the medium to long term, albeit with a higher risk-profile,” says Yogesh Kalwani, head–investments, InCred Wealth.

Kalwani adds that the potential to scale up in a large addressable market can lead to high earnings growth for multiple years for these companies. Their stocks also tend to gain from re-rating.

“Smaller companies are benefiting from the shift towards formalisation (from unorganised toward organised players), market share gains, and acceleration in the China-plus-one theme,” says Kalwani.  

Fund managers have greater opportunity to beat their benchmarks in this category. “Small caps are generally under-researched by large broking or research firms. They are also under-owned compared to other segments of the market. This provides fund managers the opportunity to add value through stock picking over the long term,” says Kalwani.

These funds have the potential to outperform large-cap funds in certain market phases. “They do extremely well whenever there is an economic recovery, and also during the early part of a bull run,” says Arun Kumar, head of research, Fundsindia.

Enter but with a long horizon

Valuations are not in the bubble zone currently. “Valuations are not cheap, but they are not exorbitant either. Long-term investors can make a good amount of money even at current valuations,” says Rachh.

The Nifty Small cap index is trading at a discount relative to the long-term average of the Nifty 50. “If you look at data since 2011, the Nifty Small Cap P/E (price to earnings ratio), on an average, has stood at a multiple of about 2.07 times the Nifty50 PE. But currently it is hovering at around 0.7x of Nifty 50 PE. Historically, whenever the relative valuation of small caps has been at 0.7x large caps, they have, on an average, delivered superior returns over a holding period of above three years,” says Kalwani.

Beware of high volatility

During bearish phases, these funds tend to crash much more than large-cap funds. “High volatility and steep drawdowns are the two key risks retail investors need to be aware of,” says Belapurkar.

The time taken to recover from steep falls is usually longer than in large-cap funds.

Kumar warns that since the category is not very liquid, and the number of investment opportunities is limited, fund managers can find it difficult to deploy money if it comes in at a rapid pace. “Large and rapid inflows can affect performance,” says Kumar.

Limit exposure

Risk-averse investors, who don’t like to see large drawdowns in their portfolios, should avoid this category.

Given its high volatility, Kumar suggests limiting exposure to small-cap funds to 10-15 per cent (20 per cent for aggressive investors) of your equity portfolio and having at least a 7-10-year horizon.

“Investing via the systematic investment plan (SIP) route will help you gain from their high volatility,” he says.

Since the small-cap segment has relatively lower liquidity, high redemption pressure can put these funds, especially the larger ones, in a spot. “Diversify across two-three funds from this category to deal with this issue,” says Kumar. If a fund witnesses large inflows or large redemptions within a short period, consult your financial advisor on whether to stick around.

Finally, Quant Small-cap Fund has given a staggering return of 50.9 per cent annualised over the past three years. Before you rush to invest on the basis of past return, pay heed to a few points. “The fund’s quantitative model needs to be tested across market cycles. Also, there is a question mark on whether the fund house’s high-churn strategy can be pursued with a larger fund size,” says Belapurkar.

Returns in 2022 muted after two strong years

Year	Small-cap funds' calendar-year return (%)
2013	4.3
2014	78.1
2015	9.5
2016	5.5
2017	50
2018	-18.3
2019	-1.1
2020	30.1
2021	62.8
2022 YTD	1.8
Source: Morningstar AWS

Note: Returns are for regular, growth funds