Consider these factors before investing in small-cap funds

After a three-year hiatus, small-cap stocks have reawakened investors’ appetite. Numerous small-cap companies have more than doubled in value since March 2020 lows, thanks to low-interest rates and a strong government and regulatory effort to stimulate the economy. A noticeable increase in retail expenditure has also aided the resurgence of small-cap stocks since June 2020.

“The debt levels across small caps have become more manageable and low debt/ equity levels give these companies more resilience in a down cycle and also give them the opportunity to participate in the upcycle,” said Aniruddha Naha, Senior Fund Manager – Equity, PGIM India Mutual Fund.

That being said, the risk and volatility associated with small-size stocks, on the other hand, cannot be entirely eliminated. For the majority of retail investors, the mutual fund method is the best option to invest in small caps.

The value research data shows that the equity small-cap has given returns of 98.65% (absolute return) for 1 year and 17.19% (annualised return), and 14.10% (annualised return) over 3 and 5 years as of June 28, 2021.

These professionally managed small-cap funds are staffed by a specialised team of researchers and analysts that are not only excellent at selecting and monitoring the best stocks but also capable of making a prudent decision in rapidly changing market conditions.

There are several factors to consider before investing in small-cap funds:

Fund manager’s strategy

Consider the fund/investing manager’s philosophy, stock selection methodology, and asset allocation. It is critical that the portfolio’s objectives align with your own objectives and risk tolerance when it comes to investing in small-cap funds.

Understanding investment horizon

Typically, it takes 3 to 5 years for the mutual fund to begin providing meaningful profits. A seven to 10 year devoted and disciplined investing period, on the other hand, helps create really higher returns and recoup any losses.

Allocation of risk

Investors should do frequent risk assessments of these funds, not just in terms of equity assets but also in terms of the whole portfolio. By utilising the knowledge of a financial adviser, you may create a portfolio that mitigates the risk and volatility associated with small-cap investments.

“One has to price in the risks associated with such investing very carefully. For example, return expectations from TCS and a small/mid-cap IT stock cannot be the same. It has to be significantly higher for the latter,” pointed out Kashyap Javeri – Fund Manager, Emkay Investment Managers.

Management

Investors should consider an Asset Management Company (AMC) and fund manager that has a track record of finding attractive stocks and keeping a close watch on risk management. Select funds with a minimum of six to 10 years of existence. Ideally, one should choose funds that have outperformed the benchmark index throughout both boom and downturn markets.

Monthly factsheets produced by fund houses provide detailed information about the fund’s performance. To determine the fund’s growth potential, evaluate the price-to-equity ratio at the time of investing. It will illuminate the extent to which the fund is overpaying for growth.

Endnote

Investors with a long-term investing horizon and a tolerance for risk might consider a 5-7% allocation to small-cap funds. They are very volatile and are characterised by magnified highs and lows during cycles.

“The period between 2014-17 shows the outperformance potential of small caps over large caps when the cycle is in favour. The period between 2018 till 2020 Covid Crash shows the sharp declines that you will have to put up with when small caps are not in favour. Overall, investing in the small-cap segment needs a long investment horizon (at least 7 years) and the tolerance to put up with higher volatility,” explained Arun Kumar, Head of Research, FundsIndia.

Additionally, a diverse portfolio of investment alternatives simplifies investing and staying on pace for long-term wealth growth.