BSE small cap index declined by 420 points in one month to 3,677 until Feb 21, reporting a 10 percent decline. This was a disproportionately steeper decline vis-à-vis Sensex, which fell by nearly three percent during the same period. Nippon India Mutual Fund’s Samir Rachh attributes steeper decline of small cap funds to the law of averaging which, he said, is now catching up with small cap funds.
Some financial experts argue that small cap stocks have lower liquidity and hence, relatively less money entering or exiting these stocks cause wider volatility. In other words, small cap funds have high ‘beta’ and are hence, riskier. Since they have higher beta, they rise more in a bull market and fall steeper in bear market.
For instance, between early January 2020 to the end of December 2021, Sensex rose by 39 percent, whereas small cap index rose 108 percent during the same period.
So, when new investors brace themselves to make large bets on small cap funds, it is imperative that they stay careful of a possible loss or market correction. Instead of getting carried away with past returns, investors are advised to focus on strong fundamentals such as high earnings, strength of management and low debt.
In view of the growing uncertainty following Russia’s attack on Ukraine, financial markets are likely to stay under pressure for some time now. This expected market correction could ensue greater volatility in the small cap funds.
Experts advise the first-time investors to stay away from companies with poor fundamentals which have high valuation. “They should also avoid buying a stock on a hearsay or recommendation made by the market novices,” says Deepak Aggarwal, a Delhi-based chartered accountant and financial advisor.
For wealth creation
Having said this, there is still a strong belief that small cap category is the one that helps in wealth creation whereas large cap stocks help investors preserve capital. Ankur Kapur, Managing Director of Plutus Capital says: “Small-cap is still an underperforming category of equity in India. The last 18 months of increase in small caps overshadows a massive underperformance in the category since February 2018. Preservation of wealth happens in a large-cap, but wealth creation is in the small-cap category.”
However, Mr Kapur has a valuable piece of advice for retail investors. He says, “Retail investors should continue with their long-term asset allocation in the small-cap space. However, as a category, retail investors should refrain from investing directly in small companies.”
So, conservative investors could take the mutual fund route to get some exposure to small cap in their quest to ‘create wealth’.