Don't chase past performance in small-cap funds

The rally in small-cap (and mid-cap) stocks, which began in August 2013, has rewarded mutual fund investors handsomely. Over the past three years, small-cap funds have delivered average annualised return of 36.46 per cent, two-and-a-half times the return from large-cap funds (annualised average return 15.45 per cent), according to Value Research. However, with net asset values of many small-cap funds trading at or near all-time highs, investors should approach the category with caution.

The primary reason investors should have some exposure to small-cap funds is that stocks in this category have the capacity to outperform. “Over the long term, small- and mid-cap stocks tend to outperform large-caps because these companies can grow at a faster pace, partly due to their smaller base,” says Vinit Sambre, vice-president and fund manager at DSP BlackRock Investment Managers.

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However, investors taking exposure to small-cap funds should be aware that these funds can be very volatile in the short term. When markets decline, these funds tend to decline much more than large-caps. Moreover, the small-cap space is not well researched; so, limited information is available about these stocks. If the fund manager does not do proper due diligence and gets his stock selection wrong, these funds can also underperform the category in a big way.

With the small-cap index trading at a premium to the large-cap index, investors also face valuation risk currently. “Given the current international scenario, if there is heightened volatility, there could be cause for worry in the short term,” says Sambre. By nature, the small-cap space also tends to be very illiquid, which makes it difficult for fund managers to exit these stocks in a hurry.

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Investors who already have exposure to the small-cap universe should apply the principle of asset allocation and book some profits to pare their exposure. “If you are making fresh allocation, then allocate 70 per cent of your money to large-cap and multi-cap funds and 30 per cent to small-cap and mid-cap funds currently,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital.

Those looking for a good small-cap fund should ensure that the fund manager has invested in high-quality businesses. Says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor India: “The quality of research that the fund manager does in this space is very important. Fund houses that have their own research setups are the ones you should go with.” Small-cap funds should constitute about 10 per cent of your equity portfolio.

Since the category is illiquid, fund size can affect performance. If the fund manager of a Rs 3,000-crore fund wants to take a five per cent exposure to a stock, he will have to invest Rs 150 crore in it. Since volumes are low, the impact cost can be significant. Nagpal suggests that investors should stick to funds in the Rs 500-1,500-crore range.

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To take care of both valuation and liquidity risk, investors entering these funds now should have an investment horizon of at least 7-10 years, according to Belapurkar. The logic: after the current rally, only if an investor sticks around long enough will he be able to get reasonable returns from these funds, whose recent stellar performance is unlikely to be repeated in the near future.

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