Reasons That Should Not Be the Basis for Investing in Small-Cap Funds

Aug 01, 2023 / Reading Time: Approx. 7 mins

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Reasons That Should Not Be the Basis for Investing in Small-Cap Funds

As we know, while investing in equity mutual funds, it is crucial to decide the suitable category - i.e. large cap, mid cap, small cap, multi-cap or sectoral. Each category has its own pros and cons; however, investors must ensure to invest in any of these categories based on their risk profile, investment horizon, and envisioned financial goals.

Currently, the small-cap space is the centre of attraction for investors. Small-cap funds in India have seen a surge in investor interest and inflows over the past few months, driven by strong returns and the rebounding market. In small-cap funds, a large portion of the investment is done in companies that are small in size or have a small capitalisation. Most small-cap funds invest around 60-90% in small caps and the rest in mid-caps and large caps to provide some stability to the investment.

[Read: Market at All-time High: Is This a Good Time to Invest in Mid Cap and Small Cap Mutual Funds?]

In June 2023, the small-cap fund space saw a massive inflow of around Rs 5,471 crore, the highest amongst all equity mutual fund categories. This has taken assets under management of the small cap category to Rs 1.62 lakh crore.

Data as of July 31, 2023
(Source: AMFI)

As you can see, inflows in small-cap funds in recent months have highly elevated. From Rs 2,182 crore, it has increased to Rs 5,472 crore within a period of two months. Small-cap mutual funds have the potential to offer higher returns than large-cap and mid-cap funds as they invest in emerging businesses that have the scope to grow exponentially. However, they also carry very high risks, as they are more volatile and susceptible to market fluctuations. As a result, you must consider a few factors before investing in small-cap mutual funds.

Why small-cap funds are not suitable for all kinds of investors?

Here are 3 elements that define why you should be prudent while investing in small-cap funds:

  • Risk Appetite:  Small-cap mutual funds are not for risk-averse investors. If you cannot tolerate seeing negative returns on your investments at specific periods, you should stay away from small-cap funds. They can experience sharp ups and downs in their performance and may even underperform the broader market. To invest in them, you must have a very strong conviction and a very high tolerance for risk.

  • Fund Selection:  You must pick a fund with a proven track record, a strong investing strategy, and an experienced fund manager. Since small-cap mutual funds require more research and analysis than large-cap and mid-cap funds.

  • Asset allocation:  Small-cap mutual funds should not form a major part of your portfolio. Your risk profile, investment goal, and time horizon must all be considered when creating a balanced asset allocation. To preserve your intended allocation, you need to review and rebalance your portfolio on a regular basis.

Having said that, Small-cap mutual funds can be a rewarding addition to your investment portfolio if you are willing to take very high risks for probable higher returns. However, as an investor, if you are also thinking of investing in small-cap funds, it is important that it is done for the right reasons.

Here are some reasons that should not be the basis for investing in small-cap mutual funds:

1. Advice/Suggestions from friends or relatives

Investors have taken a liking to the small cap segment, as seen by the inflow of funds that has poured into small-cap funds in recent months. It's likely that someone you know is a small-cap fund investor. More investors are drawn to this trend since they do not want to miss out on the market movement.

However, just because others are making investments in a particular market cap does not require you to follow since your needs and goals may differ from other investors. The decisions of fellow investors may not be the best for you; therefore, you should not base your investments on their recommendations.

2. Markets at an all-time high

Investor enthusiasm in joining the rally and earning higher returns spikes as soon as the equities indices reach new highs. Since small caps appear to offer a high potential for gains, this is the major direction that many of them adopt. Timing the market is difficult, small-cap funds are highly volatile by nature and making investments in this segment based on market fluctuations is completely inappropriate.

[Read: Market at All-time High: How to Select the Best Mutual Funds for SIP Investment Now?]

As an investor, rather than making investments in small caps based on the market trends, you should decide your allocation within the equity portfolio based on the situation, your requirements and your risk-taking ability. Thus, 'the markets reaching new highs' should not be a factor that decides the investment in a small-cap fund.

3. Higher returns offered by small-cap funds

One of the most alluring aspects that influence investors' decisions is the returns that existing funds have generated. Any investor who examines the small-cap funds' recent returns will find that they have increased significantly over the past three years in addition to the previous year.

According to data analysis as of July 11, 2023, the average return in small-cap funds during the previous year was 27.9%, and over the previous three years, it was 39.3% compounded yearly. Any mutual fund's past performance is not a reliable predictor of future returns. A fund should only be included in the portfolio if there is a clear need for it; otherwise, it will just increase the investor's risk without offering any valuable contributions. The choice of investing in a small-cap fund shouldn't be influenced by its past performance.

4. Small-cap funds closing investments

In recent days, a few small-cap funds have closed investments using the lumpsum method. There are distinct reasons for each fund house's decision, but this does not mean that there won't be opportunities to invest in the small cap market in the future. Investors are investing in small-cap funds considering they may lose out on the opportunity since the investments have been halted. This 'FOMO' (Fear of missing out) investing approach may land your portfolio at high risk.

[5. Read: Why are Mutual Fund Houses Pausing or Limiting Investments in Small Cap Funds]

The lumpsum investment was closed in order to safeguard investors' interests, but this does not mean that future opportunities to invest in this industry will not exist. In fact, the same funds have maintained both the systematic investment plan and the systematic transfer plan's investment channels available, allowing the investor to utilise them whenever they want. Thus, one needs to consider the developments in the right context, and then a proper investment decision should be made.

To conclude...

Small-cap mutual funds carry very high risk. At present, given the market conditions, mid-cap funds and small-cap funds can form part of the Satellite portion of one's mutual fund portfolio where the combined allocation does not exceed 25-30% of the assets. Additionally, investors may prefer the SIP mode of investment to reduce the impact of volatility and benefit from the power of compounding.

If you would like to add a kicker to your portfolio returns, you can add mid- and small-cap funds to it. However, you need to consider the above-mentioned factors and make an informed investment decision.

MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.

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