Investors' Hangout: How to pick the hottest small-cap fund?

What's behind the recent fabulous performance of small caps?
Broadly, there are some reasons for the small caps going ballistic or proving to be very rewarding in recent times.

Every segment of the market or even the market broadly, is also cyclical. So small caps suffered most in the recent past, not very long ago. And there is a reversion to mean - they're making a comeback. That's one.

The second is investors chase performance. If something is doing well, investors pour money and investors put more money that in turn drives it higher.

Third reason is the very design of small caps. Small sized companies have smaller equity capital, and assuming that Rs 100 crore has to be invested in stocks, if Rs 100 crore has to be invested in stocks and small companies, small companies because the liquidity is lower, because the availability is smaller, they will go up by maybe three, four times more than the Rs 100 crore which has to be invested in large companies, because large companies are available in large quantity, they can absorb the kind of flows. So, small companies, when a lot of money starts chasing them, it's very difficult, too much money chasing too few stocks. So I think it's a combination of these things, which is driving up these stocks, but you know, don't feel very happy about it. Because the other side of it is that what goes up very dramatically, also comes down once in a while.

What are the promises and perils of investing in small caps?
The promise is in the long term. When you look at the long term, and long term meaning if you look at any five year period, if you invest and hold it for five years, the likelihood of losing money in the small cap comes down dramatically. But if you look at one year, if you look at three months, if you look at six months, the likelihood of losing money goes up dramatically, because they can be very disappointing. It could be very scary and the fall can be so dramatic, it will become very difficult to stay with these funds. If you invest and it falls by 50 per cent in next to no time, it gets very hard to stay with these small caps.

So the promise is that they will prove to be very rewarding and I think here the mutual funds case becomes even stronger. If you invest in five small caps and you know three of them actually go down to zero, you will be in trouble. When you invest in a mutual fund, your money is getting spread over 60-80 stocks. With some filtration of quality, the fund manager is applying his mind, he's keeping an eye - all those things actually end up reducing your risk substantially. The benefit of diversification, the benefit of professional management is clearly getting demonstrated in small cap, not as much in large cap because the actively-managed large cap funds really struggle to beat the index. But in small caps, they are really showing very impressive numbers. So the promise is that they will prove to be very rewarding in the long run. But the peril is that if you think short term, you will be out of pocket.

What is the lesson for investors?
The lesson from this is very simple. You have to think long term. For equity, one should always be thinking long term. If you're thinking for any period of less than five years, you should not even consider equity. And think of being a regular investor, you can't really invest at one go because we have seen in case of small cap funds that they are faced with a long tail of zero return. The best performing small cap fund has delivered 28 per cent, little over 28 per cent annualised return over the last 10 years. But this fund also had a period of three years in which it gave no return, and generally that period happens to be when you bought it at the high. So the lesson is to never invest at one go. Do your SIP and keep it long term, and this is mandatory for small cap

What portion of the portfolio should you allocate to small caps?
There is no thumb rule. You should consider anywhere between 20 to 70 per cent.

If you have 20 years of investment timeframe, if you're comfortable with the massive ups and downs of the market, if you have been a witness to 2008, you can well have 70 per cent. But if you are relatively new to the market, you should have zero allocation to small caps because it is a function of your experience, it is a function of your investment timeframe. If you are investing for a three-year, five-year time frame, you should not have any small cap. So it's the time frame, your risk tolerance, which is guided by your allocation to small cap.

But let me warn you, when the times are good, we forget risk tolerance and think that we can take all the risk. You have to really look at the worst case scenario. And the worst case scenario is that small cap funds lost 70 per cent in 2008. I'm not talking of zero return, I'm talking about from the high to the low, the small cap funds were down 70 per cent. Are you ready for that? If you're not - because your Rs 100 becomes Rs 30. And that could be quite devastating for many investors. And it's a completely different story - looking at these numbers in the past and listening to narration of those numbers from me is one part of the story. When your Rs 1 lakh is invested and if you go to redeem it and you will be able to get only Rs 30,000 - that's a completely different story. You have to really experience it to be able to feel it.

How to pick the hottest small-cap fund?
You should not choose the hottest small cap fund in fact, you should choose the small cap fund which has the best long term potential . Once you start investing and once you start investing regularly, it should be in a position to deliver you the best performance or returns. And here I would say that Value Research Online could be a very helpful tool for you.

Go to Value Research Online, use the fund selector tool, choose the small cap category, make a selection of four-star and five-star fund, maybe three, four and five-star fund because you will be dropping the duds or you will you will be dropping the relative duds and look for 15 years SIP return, long term return you will get a 15 year SIP return. You will end up with funds with 15 year history, you will end up with just five or six of them which are also three star, four star or five star funds. Once you get this list, just choose one or two based on which fund is managed by the fund manager for the longest period. And if you do this, you will end up with just two. So choosing a small cap with the best potential with by the most experienced manager, which has a demonstrated track record of building great wealth for you over the last 15 years is you can do it yourself.

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This article was originally published on July 14, 2023.