Are You Excessively Holding Small Cap Funds In Your Portfolio? Read Now…

Graph: S&P BSE Smallcap index rising.

It provided a window for investors to have a re-look at those beaten down ignored market cap segment. But from the March 2020 lows, the S&P BSE Small-cap index has gained +63% as on September 22,2020.

There was a slight upward movement in the equity market, reviving investors' sentiments. Many stocks recovered significantly from their lows of March. While most sectors have been unlocked, they are operating at a limited strength and not fully functional.

This provided a silver lining in terms of valuation for value buying opportunities which was difficult earlier for fund managers across fund houses. Notably, the small cap index which suffered the most during the market crash outperformed its large and mid cap counterparts during the rally.

This spurt provided good returns to several small cap funds as well. Some funds did outperform the benchmark index. (as seen below). Take a look at the risk ratios, which actually talks of the risk- adjusted returns that the top funds will provide, and their standard deviations to know the extent of volatility of the fund and Beta generated.

Higher the Sharpe Ratio, higher you are compensated for the risk the fund has taken and a higher Sortino ratio indicates better is the risk adjusted returns. As seen below both the ratios of each fund is low but has a high beta and standard deviation.

​Being equity mutual funds, they tend to provide good returns over a longer time frame and historically small cap funds tend to outperform the large cap and mid cap funds after economic downturn.

However, it is important to note that due to the pandemic crisis many smaller companies are struggling for survival. Thus, it is important to be cautious while investing in the small cap segment, as most of the companies' bottom line reported losses.

What's in store for Investors?

Small caps usually face survival risk in case of economic downturn along with liquidity risk as the limited number of shares makes it difficult for investors to buy and sell as per their wish. That said, a strong business helmed by a well-built management team along with the availability of stock at a reasonable price can make it a very attractive investment.

The volatility caused due to Covid-19 has corrected the markets and pushed the trail P/E of the S&P BSE 500 index to over 32x levels, which is certainly an expensive zone, but small cap index is at a toned-down level of 29x. The small cap is at attractive pricing point to provide buying opportunity, with a better margin of safety, for fund houses to capture the potential gains.

Managers of worthy mutual fund schemes take advantage of such attractive buying opportunities. Process driven mutual fund houses and experienced fund managers, in fact, await market corrections like the prevailing ones.

The Indian economy is among the worst hit due to the lockdown and thus, while there will be some revival in the coming quarters, rating agencies foresaw a major contraction in GDP growth in the FY21. This is likely to weigh on the investors' sentiment and the volatility cannot be ruled out.

Remember small-cap funds are a very high-risk-high-return investment proposition as the stocks of such companies are highly volatile. When you invest in small-cap funds, make sure you have an investment time horizon of at least 5-7 years, while you endeavour to maximise returns.

If you have a high risk appetite and longer investment horizon, small cap funds can be included in the satellite part of your equity mutual fund portfolio.

Conclusion

Going gung-ho and investing all your money in the small cap funds could prove to be an imprudent decision. Nevertheless, if your risk appetite permits and if your asset allocation calls for you to invest in equities, staggering your investment would be a wise thing to do by taking exposure to other categories of equity mutual funds for the long term.

You should tread cautiously and buy selectively. Thoughtlessly investing or speculating can be hazardous to your wealth and health. Following momentum and falling for bullish index targets is something that you should completely avoid. Instead focus on your long-term financial goals and aim to consistently invest in funds that optimise returns for the level of risk they expose you to.

Editor's note:

The last few years have not been among the best for equity mutual funds. While most funds have underperformed or are struggling to match the returns of the benchmark, there are few funds that have the potential to constantly generate alpha for its investors. And we have identified five such high alpha generating funds, in our latest report 'The Alpha Funds Report 2020'. Do not miss our latest research finding. Get your access to this exclusive report, right here!

Warm Regards,
Aditi Murkute
Senior Writer

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