Small-cap funds giving bigger returns, but long-term investment could be key

Small-cap mutual funds (MFs), long viewed as riskier than their mid-cap and large-cap counterparts, appear to be gaining ground with Indian investors. Data from the Association of Mutual Funds in India (AMFI) show that in FY23, of the total MF inflows to equity-oriented schemes of Rs 1.46 lakh-crore, a sizable 15 per cent, or Rs 22,104 crore, was invested in small-cap schemes.

The trend is rather recent. The boost in buying was preceded by a strong correction in the small-cap universe. Rajesh Kumar Jain, Associate Director and Head of Private Client Business, Anand Rathi Group, told The Federal: “Looking back, from October 2021 to March 2023, most small-cap companies witnessed 20-25 per cent correction in their share prices, largely owing to rising interest rates, increased costs of raw material, power and fuel, and logistics.”

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While such headwinds impact all companies, the small-caps tend to suffer more, as their cost of borrowing to meet working capital requirement rises, in turn impacting margins, observed Jain.

In India, small-cap companies are defined as those with market caps of up to Rs 5,000 crore.

Reverse in fortunes

After a long period of consolidation, small-caps have been looking up. In January 2023, for instance, inflows to small-cap funds were at a multi-month high of Rs 2,300 crore, and this has gathered pace. Investors are flocking to these funds for several reasons.

“In the last few months, we have witnessed a fall in raw material prices, cooling inflation, a pause in interest rates by the Reserve Bank of India (RBI), and repricing of goods & services – all of which have led to gross margin expansion of small-cap companies,” Jain said. “The share price is reacting to the increase in gross margins. In the April-June quarter of this fiscal (FY24, till date), the small-cap index has risen by 20 per cent.”

According to Securities and Exchange Board of India (SEBI) rules, small-cap funds must allocate at least 65 per cent of their investment corpus to small-cap companies. These funds typically invest in capital goods and manufacturing firms, as against in the financial segment.

Long-term investment

Many small-cap funds have performed well in the past year, and some investors would be tempted to sell their holdings to cash in on the gains. However, investment managers advise a longer term investment of at least two to three years in small-cap funds, as they comprise companies that are expected to boom over a period of time.

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Analysts believe that while large-sized companies are likely to witness moderate growth, mid- and small-sized companies that are investing in newer avenues or niche segments can deliver faster growth in the long term.

These funds can generate substantial returns in a bullish (rising) market. However, they are severely impacted in a bear (falling) market.

Word of caution

“Small-cap funds are riskier than large-cap funds. However, as the beta (risk factor) associated with small-cap funds is higher than that of large-caps, small-caps tend to outperform the broader market in a rising market,” Jain told The Federal.

The trick is to set a limit on how much of investible funds goes into small-caps. This would largely depend on the risk appetite of the investor. “It is always advisable for investors to have 20 per cent allocation to small-cap funds,” said Jain. “These funds tend to create an alpha (high returns) in the overall portfolio. This is the first leg of re-rating, and we will continue to see this segment doing well.”

(This article is meant to provide information, and does not constitute investment advice.)