Another positive of small-cap stocks is that they have a high correlation with the economic growth cycle. If the economy recovers and moves to a higher growth trajectory, these funds could outperform the large-cap category.
By the same token, however, when the economy slows down, these stocks tend to get hit the hardest. Investors who get the cycle wrong may have to stay invested in these funds for a longer period than they had bargained for.
Only those who are prepared to digest the high volatility should enter this category. “Investors choosing small-cap funds should be prepared for higher volatility and they should have a minimum five-seven-year time horizon to counter it,” says Kumar.
These funds are not for all investors. “Investors who are new to equity investing, whose time horizon is less than seven years, or those who get bothered when they see large swings in the value of their portfolio should stay away from small-cap funds,” says Prateek Mehta, chief business officer, Scripbox. He suggests that such investors should stick to a portfolio consisting of a mix of large-cap, multi- and mid-cap funds to meet their key financial goals.
Investors need to pay heed to a small-cap fund’s track record before investing in it. “Long-term outperformance against the benchmark is an important factor to look at. A fund that has consistently outperformed the index is likely to be a good bet,” says Mehta.
One should also give preference to a fund manager with a long track record of handling this fund category since its nature is very different from that of large-caps. “Choose a fund with an experienced fund manager, a long track record across market cycles, relatively lower declines, reasonable size, and belonging to a reputed fund house,” says Kumar.
Allocate a maximum of 20 per cent of your equity portfolio to small-cap funds. “Considering their long-term potential for extra returns but also their significant volatility, investors with high-risk appetite may have around 10-20 per cent of their equity allocation in the small-cap segment,” says Kumar. Mehta advises a more conservative 10 per cent allocation to these funds. Investors with a larger portfolio may spread their allocation across two or three funds.
Finally, no matter how attractive small-cap valuations may seem, avoid investing lump sum money in these funds. “It is difficult to time your investments
in small-cap funds, so take the systematic investment plan or systematic transfer plan route,” says Mehta.