Why investors should remain invested in Small Cap Funds?

In this article you will read about

• What small cap funds are
• Benefits of investing in small cap funds
• What investors need to know when investing in small cap funds

Amongst equity mutual funds based on market capitalisation, small cap funds have the potential to grow significantly. The investment universe of these funds is made up of companies that rank below the 250th rank in terms of market capitalisation. As the risks involved while investing in these funds are relatively higher than that of say a large-cap fund, investment in these funds are suitable for investors who have the ability to take risks.

Small cap funds are not just for risk taking investors, it is suitable as a tactical allocation in portfolios to benefit from economic recovery and stock market cycles. Take for instance the period between 2004-2007 and 2013-2017 and one can infer how the small-cap index has posted significantly higher returns compared to the broad equity market indices. Historically, during periods of recovery and growth phases; small caps have outperformed other segments of the markets.

Source: AceMF. Above charts rebased to 1000. Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.

The upside of investing in small cap funds is the potential high growth, low price of stocks in the fund’s portfolio and possible under valuation of these stocks. Moreover, during economic revival, many small-cap stocks tend to outperform mid-cap and large-cap stocks. Investors could position small-cap funds in their portfolio to add that additional boost during different market cycles. Historical data indicates how small-cap funds have outperformed the broad market once in every decade. Investors need to demonstrate patience to stay invested for a full economic cycle to play out, for the fund to benefit from.

Small-cap funds strategy

Mostly, these funds aim to identify companies that are young and in their initial growth phase, with the potential to scale up over time to emerge as a mid-cap and eventually a large-cap stock. At the same time, not all companies in the small cap segment succeed, and it may take a long time for many of these companies to grow and succeed, for wealth creation. It is crucial for fund managers managing this fund to identify prospective winners and be able to foresee the future promise that their bets hold.

Many small cap stocks exist in new businesses that may not necessarily have a proven track record or business model, but they may possess competitive advantage or become new category creators. With such complexities prevalent in the small-cap stock universe, the stock selection process that includes such potential bets has the ability to become future multi-baggers. Then there is the possibility of some of these companies merging with bigger companies, to unlock their real potential and value.

As an investor in small cap funds, it would be in your interest to understand the stock selection process adopted by small cap funds before investing in them. Remember that stock selection in small-cap funds is across sectors, providing adequate portfolio diversification. Likewise, many managers actively seek to include small cap stocks in their small cap fund portfolio by exploring opportunities in the small stock space for re-rating, under valuation and potential earnings growth.

Smaller Cap companies by virtue of their size are generally lesser liquid compared to mid or large cap companies. The stocks are susceptible to higher volatility as a result. The ability to sustain and grow business in adverse economic conditions and adverse business cycles which may also be sector or stock specific, is generally lower compared to larger companies. However, investors in small cap funds can mitigate this risk by staying invested for a long term, as it has been observed that as holding period increases the number of observations with negative return decreases.

So, for investors in small-cap funds, the challenge is to stay patient, have the conviction on the performance of the underlying assets and ability to sit through volatility. There could be long phases in the markets when the performance of these funds may be low and insipid, but a revival in the stock markets could possibly unleash the potential for spectacular gains and wealth creation when investing in these funds.

Next steps

• Choose a small cap fund knowing the risks involved
• Understand the investment approach of the fund
• Start a SIP and consider opportunistic lump sum investment as well

This article is authored by Aniruddha Naha, Senior Fund Manager – Equity, PGIM India Mutual Fund