scorecardresearchWhy investing in small-cap funds is not a bad idea?

Why investing in small-cap funds is not a bad idea?

Updated: 10 Sep 2022, 02:00 PM IST
TL;DR.
New-age companies have proved their mettle time and again. This explains small-cap funds’ exceptional performance. The inherent volatility is eased with time and gives way to higher earnings from them.
Investing in small-cap funds comes with its set of pros and cons.

Investing in small-cap funds comes with its set of pros and cons.

How many investors have we heard of being wary of discussing small-cap funds? Not that these funds are beyond the scope of financial instruments, but because they are deemed to assume more risk than their peers. Going by the definition of mutual funds, small-cap funds track and trace the movement of small-cap companies. This also means that parking money in small cap funds translates to putting money in stocks with a small market cap.

The pain of investing in small-cap companies is that most companies listed in the small-cap index are in their early stage of growth. The fundamentals of some of these companies are really strong while others have announced their CAPEX plans to further their businesses. The risk involved is no doubt huge but is worth your money if you are ready to stay invested for the next decade or so. These companies either hold small businesses or are a part of a larger conglomerate.

Why take a bet on small-cap funds?

Many small-cap companies have grown over the period, thus, allowing investors to be a part of their journey and participate in their earnings, bonuses and dividends. Some also exploded within a short period, thus, allowing many stock market players to grow rich within a short period. Labelled as multibaggers for the exponential rise in their share prices, the growth of many such companies had set an unprecedented record in the stock market history. Stock market analysts attribute their rise to these companies’ agility and quick turnaround unlike some of the biggest companies in India that take a while to respond to market news. Scaling operations is also easy in smaller companies, thus, allowing them to jump from one project to another and finish them in time.

B Padmanabhan, Founder, Fortune Investment Services (P) Ltd says, “What is the biggest advantage of parking money in small-cap funds? First of all, the scope of growth is more in small-cap stocks as opposed to companies that have made it big in the industry. Large-cap funds cover only seven to eight industries while mid-cap funds cover the operations of around 15 different industries. So, the remaining industries are included in the small-cap sector. This implies more opportunities in the small-cap sector compared to the large-cap or mid-cap sector."

“The base of large-cap companies is too big owing to their market capitalization. So, these companies will take more time to grow in size and earnings. Now compare this to their small-cap peers, the rise to double their market cap is quicker, thus, allowing more scope for investors to earn from them", he added.

Following is the table illustrating the various small-cap fund's performance over the past 10 years.

Investment Period is between 3rd September 2012 and 2nd September 2022

Small-cap funds that have completed 10 years

Age 

(in years)

Assets under Management 

(in Crores)

Lumpsum Investment 

(in Rs)

10-year CAGR 

(in %)

Current value of the investment 

(in Rs)

XIRR 

(in %)

Current value of the investment 

on regular SIPs over 10 years

SIP of 10K * 120 

12 Lakhs

SBI Small Cap 

13.0312,82512,00,00026.14%1,22,37,97424.52%43,98,869
Nippon India Small Cap    12.0120,36312,00,00025.21%1,13,65,05124.25%43,33,712
DSP Small Cap  15.288,74812,00,00021.99%87,58,37520.56%35,48,822
Kotak Small Cap  17.587,78412,00,00021.09%81,33,24821.29%36,91,884
Franklin India Smaller Companies  16.76,81712,00,00020.45%77,13,46117.26%29,70,715
HDFC Small Cap  14.4712,93412,00,00018.73%66,80,14618.14%31,15,205
Sundaram Small Cap  17.611,95312,00,00017.58%60,60,60316.49%28,49,523
ICICI Pru Small Cap  14.933,97912,00,00017.39%59,63,37717.69%30,40,161
HSBC Small Cap Equity  17.3529112,00,00016.44%26,20,40514.93%26,20,405
Aditya Birla SL Small Cap  15.322,84812,00,00016.40%25,28,21414.26%25,28,214
S&P BSE Small Cap19.5-12,00,00016.22%29,31,75917.02%29,31,759
Quant Small Cap  25.741,91112,00,00014.94%33,28,45619.37%33,28,456
Source: Fortune Investment Services (P) Ltd 

You do not find too much information about small-cap companies in the public domain unless there is a huge order or change that can affect their growth. Then by going through the portfolio of small-cap funds, how does one assess which fund has a sound portfolio? The answer lies in the fund managers’ ability to discern their performance and then decide to invest in them accordingly.

The relatively less explored and unexplored depths of the small-cap segment mean that only those with a keen eye for the company’s business potential will benefit from their movement. India is an emerging economy with constantly shifting industry/market dynamics. Macroeconomic developments and small changes in the industry are expected to prompt the small cap industry’s growth in the near and distant future.

Also, small-cap funds tend to be volatile. This is because market tailwinds and headwinds can cause a sudden spurt in their growth metrics and vice versa. A new business announcement or a government regulation can have a tremendous effect on the valuation of small-cap companies. 

However, a sudden change in rules can push these businesses to rock bottom. The idea is to evaluate their earnings, profits, cash reserves, debt to equity ratio, business potential and the money they allocate to capital expenditure. You can also compare these companies to other companies with similar businesses that have grown big with time and turned into mid-cap or large-cap organizations over the period.

However, Muthukrishnan, a Chennai-based Certified Financial Planner has a different take on the same. He says, “Small-cap funds are extremely volatile. Though volatility is unavoidable for investors, no need to put them on such a stomach-churning ride. The ideal funds are flexicap funds which have a mandate to invest across all caps. Compared to small-cap funds, they are less volatile. They also provide decent returns in the long run. Aiming for extra few percentage points in small-cap funds can be detrimental to staying the course because of heightened volatility. The journey cannot be smooth. But to make it more bearable, flexicap funds are a better choice than small caps.”

Taking volatility into stride

Market volatility is unavoidable. This means that restricting oneself to parking money in large-cap and mid-cap funds will not relieve us of the market’s tumultuous movements. The idea is to allow scope for diversification in one’s investments, thus, explaining the idea behind allocating a part of one’s earnings into small-cap funds.

To ensure consistent and compounded returns over a period, investors must make sure to stay invested for at least 10 years. Time is the biggest factor in any investment without which the power of compounding cannot be explained. The market is for everyone. Only those willing to ride the volatility and stick to regular investments over a prolonged period will win in the long run.

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First Published: 10 Sep 2022, 02:00 PM IST