Bull market with eye on election – Should you invest in small cap funds now?

• Small caps have outperformed over the last three years or so and it is natural that there may be some time or price correction.
• Experts say that for any investor 10-15% is a reasonable allocation to small cap funds.
• If return expectations are reasonable, then small cap funds may continue to do well, albeit with higher volatility.

Small cap funds had a 2023 to remember. The one-year returns of small cap funds in this period was a whopping 42.79%, the highest of any equity mutual fund category. To put it in context, large cap funds, in comparison, gave returns of 24.92%.

If one looks at flows, small cap funds witnessed an inflow of ₹3,699.24 crore in November, slightly below the ₹4,495.13 crore seen in October. June marked a peak for these funds, recording a remarkable ₹5,472 crore inflow, maintaining the highest inflow among equity fund categories for three consecutive months.

The uptrend is propelled by the ongoing economic recovery, boosting earnings for smaller high-growth potential companies. Investors have exhibited optimism about these firms' future, driving their interest in small-cap funds. The AMFI chairman attributed this trend to a recency bias, reflecting investors' focus on recent events or performance.

The big question: Should you invest in small cap funds now?

Dalal Street has been seeing a bull market for a while now. However, come 2024, market gurus expect the pace to cool off a bit at least till the general elections later in summer. So, as they say, good times may last, but there is no guarantee of the same. Going ahead, small cap funds may not give the kind of returns that they gave in 2023. Which brings us to the all-important question.

The stock markets, especially small caps have performed very well over the last three years or so, so it is natural that there may be some time correction or price correction.

If you have SIPs in small caps should you continue?

The world of small caps is very large and there may be pockets of opportunity that may linger which the fund manager can find for you and which will give reasonable returns going forward.

“For any investor we think 10-15% is a reasonable allocation to small cap funds. If you do not have that allocation, you should continue with your SIPs,” says Chirag Mehta, CIO, Quantum AMC. You can even increase your exposure to the small funds category.

If the exposure to small-cap funds is very skewed, one may look at rebalancing

Given the run-up in small cap funds, if one’s allocation to small-cap funds is very skewed, one may look at rebalancing their portfolio.

“In that case, you take money off the table, book profit and pay taxes. Or you can change your incremental allocation and use that to rebalance your portfolio,” says Mehta.

Agrees Chandraprakash Padiyar, senior fund manager Tata Mutual fund, “Asset allocation is certainly the most important part in any portfolio. Whenever asset allocation skews towards one particular part of the market, because of appreciation, there is certainly a case to rebalance.”

Temper return expectations

If return expectations are reasonable, then small caps as a category may continue to do well. In the last 5 years small cap funds as a category has given returns of 24.72%.

“All of us are optimistic about small cap funds in the medium to the long term, but in the next one to two years the incremental return expectations need to be in line with a 10-15 years kind of return and not what has happened in the last 3-5 years. If return expectations are reasonable then small cap funds may continue to do well, albeit with higher volatility,” says Padiyar.

So investors should not expect a similar performance in the next two years, but relatively lower returns.

Do not abandon small-caps altogether

Given the large opportunity, you should not abandon small cap funds alothether.

“Currently on a historical valuation basis small caps may appear slightly expensive than the large caps, but if you see the earnings growth in the segment, it is significantly larger as well. So from an opportunity standpoint you should not miss out and say that I should exit now,” says Mehta.

Hence , an investor should not exit the category fully.” Manufacturing is a big theme for India for the next 5-10 years. If these businesses were to scale for the next 3-5 years then this segment genuinely makes a lot of sense for the long term. Investors investing in small cap funds should take a long term view,” says Padiyar.

Summing up

Small cap funds are more risky than any other equity fund, so when investing in small cap funds, you do not just look at the past track record, but also at other safeguards the fund has, for example, what proportion of allocation they have as a market cap of the company, what is the liquidity profile of the investments they have got into and so on.

It is important not to be carried away by the momentum you see in the segment, but if you do not have adequate exposure, you should not miss out.