Smallcap funds: Normalised valuations make a case for long-term investors

Allocation should be commensurate with investor's risk appetite and horizon

Smallcap equity funds have returned to prominence, with several fund houses rolling out new offerings in this category. The DSP Nifty Small Cap 250 Index Fund and its exchange-traded fund (ETF) recently opened for subscription. Over the past month, two actively managed smallcap new fund offers from Helios Asset Management Company (AMC) and Samco AMC closed for subscription. Two ETFs from Groww AMC and Mirae AMC also began trading. These additions expand the already large universe— 58 funds with assets under management worth ~3.86 trillion—of active and passive funds available.

 

These launches come at a time when smallcap funds have sharply lagged their largecap peers. Smallcap funds, on average, have lost 5.4 per cent, while largecap funds have gained 5.4 per cent. Despite this divergence, experts believe current conditions offer an attractive entry point for long-term investors.

 

“After the past year’s correction, excess froth has reduced, and valuations have normalised, making the segment healthier. Near-term conditions may remain choppy due to broad market volatility, but long-term prospects are solid with improving earnings visibility,” says Viraj Gandhi, chief executive officer, Samco Mutual Fund.

 

The segment remains attractive for long-term investors. “Smallcap funds offer meaningful long-term growth potential and give access to emerging leaders,” says Ajay Khandelwal, fund manager, Motilal Oswal AMC.

 

A wide mix

 

Smallcap equity funds are mandated to allocate at least 65 per cent of their portfolio to smallcap stocks, defined as companies ranked 251 and below by market capitalisation. Many of these funds track benchmark indices such as the Nifty Small Cap 250 Total Return Index (TRI) and the Nifty Small Cap 50 TRI. Smallcap equities also tend to be more diverse than their largecap counterparts, spanning a broad range of sectors, with some companies emerging as category leaders in their respective sectors.

 

Can be volatile

 

Smallcap funds, while offering the potential for superior long-term returns, also expose investors to elevated levels of risk. “These funds come with higher short-term volatility, deeper drawdowns, and liquidity constraints during periods of market stress,” says Trideep Bhattacharya, president and chief investment officer–equities, Edelweiss Mutual Fund. For instance, these funds had, on average, declined 19 per cent in 2018.

 

Active vs passive

 

Investors in this segment can opt for either actively managed or passively managed schemes. Many experts believe that the smallcap space lends itself well to active stock selection. “Market inefficiencies are widest here, and a disciplined, bottom-up, research-driven selection approach can generate significant alpha over the cycle. Active managers can also manage liquidity, concentration, and valuation risks far more dynamically than passive strategies,” says Bhattacharya.

 

Investors keen to avoid fund manager risk and those seeking low-cost options may consider passively managed schemes. “When selecting between active and passive options, consider risk-adjusted returns across cycles, especially performance during downturns, to ensure smoother outcomes and downside protection,” says Khandelwal. Choose passive options with low tracking error.

 

Regardless of the approach chosen, use a systematic investment plan (SIP) to navigate volatility effectively.

 

Long-term bets

 

Investors seeking relatively higher returns at relatively higher risk should consider allocation to smallcap equity funds. “Investors with high risk tolerance, a minimum 5–10-year horizon, the emotional bandwidth to stay through drawdowns, and experienced investors who can evaluate manager skill, should invest in smallcap funds. Retirees needing income or those who panic-sell in downturns should avoid them. Beginners with no prior equity experience should first build a base in flexicap or multicap funds or use multi-asset funds,” says Bhattacharya.

 

Avoid outsized allocation to this segment. “Allocation should reflect investment goals and the ability to withstand volatility. Typically, 5–10 per cent of a portfolio suits most investors. Aggressive investors may go up to 15 per cent,” says Gandhi.        Strong long-term track record  

Periods	Category average return (%)
1-year	-3.6
3-year	18.9
5-year	25.2
10-year	17

Returns are of direct plans. Above 1-year returns are annualised.

Source: PBCS.in   The writer is a Gurugram-based independent journalist