Fast and furious

Over the last year and half, in the ongoing bull run, small caps have hogged the limelight. Since April 2021, S&P BSE 250 SmallCap TRI has delivered 106.12 per cent as of July 2021, thus more than doubling an investment made in the index.

However, if one looks at the long-term numbers, the picture isn't as much rosy. The seven-year and 10-year returns of the BSE 250 SmallCap TRI stand at a modest 13.4 and 11.3 per cent per annum. This suggests that the short-term blockbuster performance of small caps is often not reflected in the long-term numbers, thanks to calamitous falls they undergo amid market corrections. Thus, investors who are dazzled by short-term returns from small caps and hence are attracted to them need to put things in perspective.

Despite this, the small-cap segment does provide ample opportunities, as seen by the long-term returns of some of the top funds. Hence, if you decide to invest in this space, you must go with a fund that has proved its ability to navigate this tricky segment.

AUM trends
After the pandemic-led crash in March last year, the category witnessed an investor exodus as the markets seemed to recover (see chart 'Same old story'). Between July 2020 and February 2021, small-cap funds witnessed a net outflow to the tune of Rs 4,300 crore. Interestingly, during the same period, the AUM of the category grew from approximately Rs 44,700 crore to Rs 67,800 crore, at an annualised rate of a whopping 87 per cent, thanks to the mega rally in small caps.

This is not the first time that such a trend is seen. Time and again, whenever investors are fearful, they take money out of the market and then miss out on the big bull run that follows the crash. This is particularly relevant to small-cap funds, where the return-generating periods come in cycles and those who are not invested during those times tend to have a dismal return experience.

At about Rs 86,000 crore (as of June 2021), the small-cap category currently makes up about 2.55 per cent of the total industry AUM from about 1.75 per cent about a year ago. The top four funds by assets alone constitute more than half of the AUM of the small-cap category, which has 27 funds in total. One of the reasons responsible for this is that more than half of these funds were either launched less than three years ago or transitioned to the small-cap category post the re-categorisation exercise in 2018. Thus, most of them have yet to prove themselves and establish a track record.

All that glitters is not gold
The small-cap category has outperformed all the major equity categories over the last one year. At the end of July 2021, the one-year return of the small-cap category stand at an average of 108 per cent, which is about 30 percentage points higher than the returns from the mid-cap category, the next best performer. Thus, if you look at the returns over any of the shorter time-frames (see 'Rein in your horses'), the small-cap segment triumphs over all other major categories by a significant margin. However, if we look at the other end of the spectrum, one sees that the quantum of outperformance over other categories significantly reduces as we increase the investment horizon.

Also, the extra returns that you earn with small-cap funds come at a higher volatility, both in the short and long terms (see 'Volatility as measured by standard deviation'). This extreme volatility can give many investors sleepless nights. Long-term investors in the space would have seen the worth of their investment drop by about 40 per cent in a month and as high as 33 per cent in just a week in the March 2020 crash.

As of this writing, after a spectacular rally, the small-cap index has corrected by about 5 per cent in just one week (as on August 11, 2021), which suggests that this category of stocks is capable of sharp moves in both directions. Thus, investors in this high-volatility segment pay not just in terms of costs but also in terms of high emotional strain from time to time.

So, if you are thinking of investing in this space, you must have the stomach to digest high volatility. Also, given the recent high returns, moderate your return expectations. Like other equity funds, invest in small-cap funds only through SIPs.

Our take
Investors who have the risk-taking capabilities and believe that one cannot stay wrapped up in cotton wool and aspire to earn handsome returns can invest in funds in the small-cap space. However, that does not mean they throw caution to the wind and go all out investing in them. Understand that small-cap funds should play only a supplementary role in any portfolio and one should not have more than 10-15 percent allocated to them. For most investors, investing in three-four flexi-cap funds would suffice as these funds can provide you the necessary allocation to the small-cap segment.

Further, the choice of the fund in this space matters more than that in others. Do look for factors such as consistency, track record and, more importantly, the experience and skill of the fund manager. A seasoned fund manager in this space can navigate it much better than others.

For our recommended funds in this space, see the September 2021 issue of 'Mutual Fund Insight'.