Planning to invest in small-cap funds? Be prepared for high volatility

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If you had invested in small-cap funds towards the end of 2017 or the start of 2018, there would have been significant erosion in the value of your investments over the past couple of years. The SmallCap Index fell 23 per cent in 2018 and 8 per cent in 2019. Lately, however, there has been recovery. Small-cap funds have delivered an average return of 16.44 per cent over the past six months.

The recent upturn has prompted experts to recommend this category to investors. Investors, however, should know that this category is only for investors who have considerable risk appetite. Risk-averse investors should not enter it despite the potential for high returns.  

Experts cite valuation comfort in this space, compared to large-caps. While valuations of small-cap stocks are not as expensive as they were at the beginning of 2018, they are also not as cheap as they were in 2013. “Valuations are close to the long-term average,” says Arun Kumar, head of research, FundsIndia.

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.

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