Up 8% when small caps were bleeding. How?

When markets turn choppy, most small-cap funds feel it first and hardest. Aditya Khemani’s doesn’t. As Head of Equity at Invesco Mutual Fund, Khemani has built one of the best-performing small-cap funds in the country. And notably, a large part of that alpha came in the last two years, when the small-cap benchmark was down roughly 1.5 per cent while his fund was up close to 8 per cent. With over 20 years of experience and a framework built around quality, risk management and bottom-up stock picking, he has shown that small cap need not mean reckless. In this conversation, he explains how he thinks about portfolio construction, position sizing, and manages valuation risk in a richly priced market. We’d like to understand a little more about how your investing style has helped you navigate the last two years of volatile markets, and in turn generate the alpha that makes Invesco India Smallcap one of the top funds in its category. For context, since September 2024, the small-cap benchmark is down about 1.5 per cent, while your fund is up close to 8 per cent in that time. What are the two or three key decisions that led to close to 10 per cent outperformance in such a volatile market? The first thing is the quality of the portfolio. We keep talking about risk management, and for us as fund managers, it’s the most important thing apart from returns. If you make the quality of the portfolio good, it stands out in bad times — because in good times, most portfolios do well, but it’s in bad times that risk management really comes to the fore. So the first thing is maintaining a high quality of the portfolio. Second, two and a half years ago, I decided that we should not be running a very small-market-cap fund. So we purposefully reduced exposure to stocks below Rs 7,000–8,000 crore in our portfolio. Over the last 18 months, a lot of the pain has been in that part of the market, so staying away from the smaller-market-cap names has helped us. Today, less than $1 billion market-cap names make up just 8–9 per cent of the portfolio. Third — and this isn’t specific to the small-cap fund — two and a half years back, after four to five years of a rally, a lot of spaces had become very expensive, and investors weren’t differentiating between good and bad businesses; everything was getting a high valuation. At that point, we reduced exposure to some of the very overheated sectors, including industrials. Most industrial companies two and a half years back were trading at 40–50 P/E — these are cyclical companies. So when even a slight bit of earnings or growth deterioration happened over the last two years, there was a knock in terms of the multiple investors were willing to pay. So navigating the overheated parts of the market slightly better also helped us. These are things we want to do consistently, because small cap tends to be riskier than other parts of the market, so it’s on us as fund managers to manage that risk. The common notion is that because you’re taking the highest risk in small caps, the return expectation should also be high — but that hasn’t proven true historically. If you look at the last 10 years, the small-cap index has given roughly 14–15 per cent CAGR, and mid caps have given a