Small cap funds had an outstanding 2023 with some funds even giving returns of 60 per cent or more. According to Value Research, small cap funds as a category has given 37.77 per cent returns over the past one year. Experts have warned that such a performance in small cap funds may not be sustainable. However, small cap funds have continued to do well.
PL Wealth Management, Prabhudas Lilladher’s wealth management arm, in its latest study on mutual fund performance analysis cited that the AUM (assets under management) of equity mutual funds has surged by 3.10 per cent sequentially to Rs 26,43,291 crore in September 2024 from Rs 25,64,069 crore in August 2024 (excluding Sectoral / Thematic Funds). The study, which is based on 287 open-ended equity diversified funds, cited that 48 per cent of these funds have outperformed their respective benchmarks over the past one month, ending September 30th, 2024.
The study also finds that small cap funds were the best performing category where 75 per cent of the schemes outperformed the benchmark.
In this scenario, what should be your investment strategy when it comes to small cap funds?
Why Small Cap Funds?
First, let us understand why you should be investing in small cap funds. Small cap funds bear the most risk, and hence have the potential to provide the maximum returns.
“Investing in small-cap funds can be a great way to enhance your portfolio, particularly if you have a long-term horizon of at least seven years and can handle short-term volatility,” says Pankaj Shrestha, Head - Investment Services, PL Capital - Prabhudas Lilladher.
According to SEBI's classification, the small-cap universe is extensive, with 4,779 companies, and the 251st company has a market capitalization exceeding Rs 30,000 crore, illustrating that the segment is quite diverse.
Small-cap funds often offer unique sector exposure and themes that are less common in the large-cap category. Historically, small-cap categories have outperformed large-cap ones over the long term, making them an attractive option for wealth creation. “Therefore, if you’re looking to build your portfolio for the future, consider including small-cap funds as a strategic component. Additionally, you may consider investing through a Systematic Investment Plan (SIP) to build your exposure gradually,” says Shrestha.
Should You Make Fresh Investments In Small Cap Funds?
However, one needs to keep in mind that asset allocation is the key to creating long term wealth. Let us say you have an asset allocation of equity debt of 75:25. Inside equity, you want to allocate 20 per cent to small cap funds. Since small cap funds have performed very well in the last year, the asset allocation may be skewed.
“When considering fresh investments in small-cap funds, it's important to evaluate your overall asset allocation. If adding more small-cap exposure significantly skews your allocation away from your target, you might want to assess whether that aligns with your investment goals and risk tolerance. Remember, diversification is key to managing risk and achieving a balanced portfolio,” says Shrestha.
To Sum Up
It is important to be aware of the risks associated with small cap funds. “You have to understand that small cap funds will go with lots and ups and downs in between because they are high risk products. If you are an investor in a small cap fund, I would recommend you that you should have a horizon from seven to ten years” says Soumya Sarkar, Co-Founder, Wealth Redefine, (AMFI registered MFD).
While small-cap funds offer high returns, they come with significant risk. It's essential to review your asset allocation, maintain a long-term perspective, and ensure diversification to balance your portfolio and meet your investment goals.
