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Small-cap funds attract investors despite market downturn: Are they worth the volatility?

Industry experts suggest investors are banking on long-term returns and historical outperformance of small-cap funds compared to large-caps. But caution is advised.

Small-cap funds attract investors despite market downturn: Are they worth the volatility?

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Despite a significant drop in the small-cap index over the last few months, investors remain optimistic about the small-cap fund category. Small-cap funds have seen net inflows of over Rs 2,200 crore per month in the past two months. In fact, in January, small-cap funds were the highest receiving category with flows of Rs 2,255 crore among the 11 categories of equity funds.

Industry officials suggest that investors are investing more during the market downturn, anticipating higher returns in small-cap funds compared to large-cap funds. Small-cap companies exclude the top 250 companies based on market capitalisation and are more prone to volatility as they invest 65 per cent of total assets in equity and related securities of small-cap firms.

Small-cap funds offer long-term return potential
The S&P BSE Smallcap index corrected by almost 6.30 per cent over the last three months, while the BSE Sensex and BSE Midcap Index have fallen less than the small-cap index. Despite this, investors are attracted to small-cap funds due to their long-term return potential and history of outperforming large-cap funds.

"Investors have realised that small-cap funds can outperform large-cap funds in the long run. Even the surge in small-cap funds seen after each correction gives investors' confidence in the category's prospects. When the category is experiencing intense volatility, investors are increasingly attempting to add more money," said the CEO of a major fund house.

Even in 2020 (despite the sharp market correction in March), small-cap funds delivered returns of 32.11 per cent, compared to 15.75 per cent for the Sensex and 19.87 per cent for the midcap index. In 2021, the small-cap index generated returns of 62.77 per cent, compared to nearly 22 per cent for the Sensex. Over the past decade, small-cap funds in India have delivered the highest average returns of 19.42 per cent, followed by technology funds and mid-cap funds.

Some fund managers are also buying small-cap stocks after the market correction because they see opportunity in the sector. Some schemes in the ELSS (equity-linked savings scheme) category have begun to increase their holdings of small-cap stocks. For example, small-cap exposure has increased in schemes such as ICICI Prudential Long Term Equity Fund, Invesco India Tax Plan, and Motilal Oswal Long Term Equity Fund over the last six months.

Investors should be cautious though
Investors should keep in mind that small-cap funds are inherently more volatile than large-cap funds and long-term time horizons are necessary to generate good returns. Investors must be prepared to endure intense volatility along the way. It is recommended that small-cap funds should account for no more than 10-15 per cent of a portfolio's total value.

Suggested read: Small-cap funds: Good, bad or ugly?


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