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Should I Invest in small cap funds?

Updated: Apr 2

Small-cap funds have been leading mutual fund performance this year, driven by the increased return potential they offer. Investors have been pouring money into these funds, where the associated risks are also becoming more pronounced.

While this space is potentially very rewarding, it is also known for sharp drawdowns and protracted recoveries, raising fears of investors getting their fingers burnt. So, should you consider investing in this space? How much return can you expect? What are the associated risks? Let’s understand.

Before getting into the details, let's understand what a small-cap fund is.

What is a Small cap fund?

Small-cap companies are those smaller players in the market, with a market capitalization of less than ₹5000 Cr. They're often in their early growth stages and can offer more potential for growth compared to the big, established players. Take ITC, for example. It holds a substantial 78% market share in India, but its growth potential is limited compared to a smaller company in a high-growth sector like solar energy.

Small-cap companies, being in their early stages, often encounter rising competition and the risk of failure due to limited information, leading to higher volatility. One factor in navigating the small-cap space is solved by holding a small-cap fund - as an experienced fund manager is best equipped to solve for the downside risks faced by individual small-cap stocks.

So how can you make the best of the oppurtunities presented by a small cap fund

Opportunities presented by a small cap

In 2023, small-cap funds stole the spotlight in equity markets, Their one-year returns soared to 59.38%, the highest among all equity market categories. In comparison, large-cap funds yielded returns of just 24.92%.

This marked the strongest one-year return for small-cap funds since 2015, highlighting their robust growth potential in contrast to their counterparts.

Small cap performance
2023 Small cap Performance

Comparing Annual returns
Comparing Annual Returns

Taking a historical perspective on the opportunities presented by small caps: Over the past 10 years, small caps have delivered a staggering 336% absolute return, outperforming the Nifty large caps, which yielded a 254% return.

What makes a small cap capable of its growth potential?

  • Higher Growth Potential: Small-cap companies often exhibit higher growth potential compared to larger counterparts. This can be attributed to factors such as being in the early stages of their business lifecycle, operating in niche markets, or offering innovative products/services that lead to rapid expansion.

  • Market Inefficiency: The small-cap market is typically less efficient than the large-cap market. This inefficiency can result in mispricings and undervaluations, offering investors opportunities to capitalize on the growth potential of small-cap stocks before they are fully recognized by the broader market.

  • Law of Large Numbers: It's easier for a $1 billion company to double in value to $2 billion than it is for a $1 trillion company to increase its value to $2 trillion, limiting the growth potential of large-cap stocks compared to their smaller counterparts. This is because growth rates tend to slow as businesses mature and become larger.

Government Policies and the Small-Cap Ecosystem

  1. Policy Tailwinds: Government initiatives such as "Make in India" and "Startup India" have emerged as catalysts for the growth of emerging businesses, building a conducive environment for local manufacturing and entrepreneurial endeavours. Through these policies, the government aims to stimulate economic development by empowering indigenous industries and the emergence of new ventures. For instance, Dixon Technologies: Back in 2019, its stock was valued at Rs 690. Fast forward to today, it's an impressive Rs 7,158 – a whopping 1,245% increase! If you were to look at much of its growth post-2019, it came with the government's reliance on an ecosystem favouring manufacturing in India.

  2. Tax Breaks and Incentives: Government policies offering tax breaks and incentives such as the PLI schemas have been instrumental in fueling the growth of small-cap companies. Reduced tax burdens and subsidies can enhance the financial viability of these businesses allowing them to reinvest in expansion, research, and development.

  3. Capex Infusion: Capex Infusion: The primary driver behind the tremendous growth in the small-cap sector and the favoring of Indian equities lies in substantial Capex infusion from the government. Investments are primarily directed towards infrastructure, setting a virtuous cycle in motion. Government spending boosts demand, prompting businesses to expand, create jobs, and enhance productivity. This cycle amplifies economic activity, attracting more domestic and foreign investment due to improved infrastructure and the business environment.

Risks in Investing in Small Caps

In February 2024, SEBI and AMFI sounded the alarm about an impending froth or bubble formation in the small and mid-cap sector. They directed AMCs to limit inflows into small and mid-cap funds and cautioned investors to be aware of the risks of overvaluation in the small-cap space. This news caused a ripple of panic throughout the market, leading to a significant sell-off of 12.4%, following a continuous bull run of 59%What was really going on behind this sell-off was a culmination of factors that had been brewing in the small-cap sector since 2023. During that time, there was a spike in the market with notable earnings growth during FYQ2, led by robust consumer demand, along with both foreign and domestic investments, resulting in a surge in capital expenditure. This led to a stronger fundamental outlook and increased inflows into small caps.

However, amidst this high growth, investors started pouring money in for potential quick gains without considering any company fundamentals such as what exactly was driving this growth and for how long it could sustain. The lack of attention to fundamentals, coupled with investing in the market without valuation insight, led to overvalued stocks. The Price-to-Book (PB) ratio reached a peak of 3.97, indicating that stocks were valued at 3.97 times the assets held, surpassing the 5-year average PB ratio of 3.29.

This overvaluation posed significant risks for investors, particularly in the small-cap space.

Market Risks: Small caps are highly sensitive to changes in the economy, such as recessions, policy shifts, or regulatory changes. Their vulnerability stems from their perceived riskiness and limited access to capital during market volatility. As a result, small caps experience significant declines in value during such market volatile conditions.

Portfolio Risk: Investing in a small-cap fund just because it seems profitable, without a clear plan, can be risky. Without knowing how long one intends to invest or how it fits within the overall investment portfolio, investors might panic when prices drop, following what everyone else does. This can lead to hasty decisions such as selling the asset if there is perceived risk in the small-cap market without understanding its long-term orientation. It's important to have a solid plan that considers goals and the volatility of the market so that one can fully leverage the opportunities that a small-cap fund offers to the portfolio.

Liquidity Risk: Additionally, there's the redemption or liquidity risk to consider. With small-cap funds managing larger amounts of assets, the time it takes to liquidate investments increases. For instance, Nippon India Small Cap Fund takes up to 27 days to liquidate 50% of your invesmtnet, particularly in emergencies. While small-cap funds offer the potential for high returns, investors need to weigh this against the liquidity risk and the time it may take to convert their investments into cash when needed. This liquidity risk adds another layer of complexity to investing in small caps, highlighting the importance of thorough risk assessment and portfolio diversification strategies.

So should you invest in Small caps?

Currently, what makes the Indian small and mid-cap space particularly attractive is the country’s robust policy stance, positioning it as one of the strongest countries globally in terms of stock market performance. With a substantial capital expenditure push from the government - The government has raised the capital expenditure target by 11.1per cent to Rs. 11.11 lakh crore for the next fiscal year starting April 1. This would be 3.4 per cent of the GDP and a continuously growing domestic demand, fueled by a rising working-age demographic, there is significant potential to capitalize on the country's emerging economic growth.

This potential is already evident, with substantial foreign investment flowing into India. In fact, India's stock market has recently surpassed Hong Kong's to become the fourth-largest equity market globally for the first time. The main drivers of India’s growth are its increasing consumer demand and significant foreign institutional investor (FII) inflows.

Moreover, India's vibrant startup ecosystem further augments its growth trajectory. Looking ahead, these factors are poised to sustain India's rising demand over the mid to long term, making the Indian small and mid-cap space a compelling investment opportunity.

The caveat here is that since this is a long-term plan, to capitalize on the opportunity, you need to hold your investments for a minimum period of 3-5 years

How to go about investing in the small cap space?

1. Long-term perspective: Investing in small-cap stocks requires the ability to weather market cycles and economic downturns. Small-cap stocks may be more vulnerable to market downturns due to their higher volatility and lower liquidity. Therefore, they are prone to interim market downturns. Thus, investors should have a long-term horizon of at least 3-5 years. This is evident from the graph we discussed above, as in the long term, the market has always trended upwards. Remember, if you need short-term liquidity from the capital allocated in small-cap funds, it's not a good idea to liquidate when the market is down. Instead, consider liquidating when the market is up. Consider such money to allocate in a large cap or debt funds which consists of less volatility.

2. Have a plan: When the market experiences downturns, it's common for investors to panic or worry, especially if you don't fully understand the risks involved & its long term oprptunity. However, it can be easily mitigated when you have a clear understanding of why you initially invested. Knowing the rosins behind holding onto your investments for the long term, given the fact that you have held on to a good fund, provides a solid foundation for confidence in long term opportunity of a small cap fund. Whether it's for retirement, education, or other financial goals, having a well-defined purpose can help you stay focused during market downturns.

Additionally, being invested in a good fund with a track record of performance and strong management can further reinforce your confidence in your investment strategy. This clarity of purpose and confidence in your investment choices can help you weather short-term market fluctuations and stay committed to your long-term financial goals.

2. Understand the risks: When investing in small caps, there are always certain market risks. However, investing through a mutual fund eliminates most of them by investing in companies that have strong growth potential backed by good earnings. All you need to do is find a good mutual fund. While it may take some time to find the right fund, researching in a good mutual fund can benefit you in the long term. And that's exactly what we focus on here at Cambridge Wealth—finding the right fund among the 5000+ options.

Learn more about what investing with a plan can mean, how it sets your financial journey in motion for the future. 

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