The crash in small-cap funds may not be bad news. What should investors do?

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Yesterday’s hero has become today’s villain.

Small-cap mutual fund (MF) schemes have fallen by nearly 10 percent on an average so far this year. This is completely opposite to how they behaved in 2021, when these funds gave more than 60 percent returns, on an average, on the back of rising equity markets. So far this year, the BSE Sensex TRI index is down roughly 5 percent, but the BSE 250 Small Cap index is down about 12.5 percent.

The question is: is the worst behind us, and if so, is this an opportune time to increase allocation to small-cap stocks and funds, given their ability to outperform the broader market in the long run?

Understanding how volatile small-cap funds can get

Small-cap funds can be extremely volatile. There are two things to look out for in small-cap funds. First, the category itself is very volatile in terms of performance. For example, in 2019, the BSE 250 Small Cap index delivered a negative return of around 8.5 percent, in 2020 the index was up nearly 27 percent, and in 2021 it was up almost 60 percent.

Small – cap funds can be volatile. In some years they can top the charts, in other years they can fall faster

Second, within the category of small-cap stocks, as defined by SEBI, there are more than a 1,000 stocks to choose from. The relevance of choice or bottom-up stock selection becomes apparent when you consider the diversity in performance of small-cap funds, both in the short- and long-term horizon <See table>.

Small – cap funds depend a lot on fund manager picks and therefore tend to show a wide divergence in performance

Which brings us back to what should investors do — is it a good time to ramp-up small-cap allocations, and how does one pick from the universe of stocks?

Key to wealth creation, but roadblocks galore

Historical data reveals that investing in small-caps as a category will be volatile in the immediate three-five years, but smoothens out over time — longer periods of 10 years and more. While stock selection will always be important, the overall economic environment and macro policies also have an impact on the short-term trend, if you are looking at starting on the more favourable side of the inherent volatility.

“Smaller-sized companies are not resistant to macroeconomic changes. Valuations for growth-oriented stocks get challenged in times where interest rates are trending upwards and we are witnessing some of that happening now. Many small-cap companies are growth-oriented, and hence, valuations are getting revised,” says Trideep Bhattacharya, Chief Investment Officer – Equity, Edelweiss Asset Management Limited.

While smaller-sized companies may show a higher sensitivity to macro changes, as some lack the cost-benefit of large-scale operations, in the case of other newer small-sized companies, the experience of managing business dynamics across economic cycles could be missing. But there is a silver lining, too.

According to Harish Bihani, Senior Fund Manager, ICICI Prudential AMC Ltd, “Changing macros do impact small-cap companies. However, there could be a whole host of companies which remain unaffected or some which benefit from negative macros. The universe of stocks in this category is sufficiently large and opportunities of all kinds are present for investors.”

Bhattacharya also spoke about small-cap companies which operate in niche business segments. These are industry leaders with the ability to grow earnings in the long term, without necessarily diluting their capital base, and hence, can be a strong source of wealth creation over the medium term.

There are also companies which stand to gain from the current rise in commodity prices. Some of these can only be found in the listed small-cap category.

Macro risks can cause volatility in prices, and if the overall market corrects sharply downwards, then illiquidity of the shares itself can impact prices disproportionately. Experts say that investors need to keep a reasonably long time horizon of 10 years or more for small-cap stocks and funds during which time the volatility caused by macro variables can smoothen out and business fundamentals take over.

Bhattacharya says, “The Indian economy is still under-penetrated and the long-term opportunity for well-managed small-cap companies is a growth story which can potentially deliver premium returns.”

Not enough time to research small-caps? Try the mutual funds rout

Stock selection in any category requires research about the company and its business. In case of large-cap stocks with a huge number of investors, both domestic and foreign, reams of research is available from brokerages and even regular news flows. For small-cap companies, external research and news flows are limited, simply because of the relatively lower level of investor holdings, and consequently, interest in the workings of a small company.

If you don’t have the wherewithal to do this research yourself, a good option is to go through small-cap mutual funds. There is a good enough choice of around 25 such small-cap mutual fund schemes. However, here too, the underlying characteristics of short-term volatility and importance of selection hold good.

It is too much to expect that individual investors will go about analysing fund portfolios. If that is difficult to do, then the next best option automatically leans on looking at past performance or returns. There is no sure shot formula, but here are some pointers you can keep in mind.

Look for consistency of performance against the benchmark and the ability to preserve capital during a downturn, rather than chasing the top performer in the category. A fund which has hugely outperformed other peer funds in one year, may have underperformed significantly in prior years or may underperform, going forward. Instead, lower volatility in annual returns is desirable.

Try to stick to the tried and tested funds with performance history of at least three-five years.

Lastly, each small-cap fund manager will have a differentiated strategy to generate excess returns. So, diversifying across two-three schemes can help.

Bihani says, “In our portfolio construction, along with focusing on well-managed companies and fundamentally strong companies where there may be a mispricing of shares, we are conscious about avoiding poorly-managed companies and those where financial health, both on the income side and the balance sheet, is suffering.”

Over the last 10 years, the Sensex 250 Small Cap index has delivered a rolling return of roughly 9 percent, whereas the average rolling 10-year return across 11 small-cap funds is around 15 percent. This is also why active funds work best in the small-cap space, compared to passive ones.

It’s important to have small-cap mutual funds in your portfolio. Only, be mindful of the volatility. The best way to beat the volatility is to increase your investment time frame.

For those who wish to invest in small-cap funds now, avoid putting in lump sums. Stagger your lump sum investments over the next six-nine months. Else, start a Systematic Investment Plan (SIP).

Dhuraivel Gunasekaran contributed to this story

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