With small-cap funds, it's either Sholay or chhole

Small-cap funds are all the rage. They have received money of epic proportions from investors (north of Rs 24,000 crore between June '22 and May '23), delivered punchy double-digit returns (over 20 per cent over ten years) and are climbing new highs as we type. Yet, small-cap funds should come with a health warning: they aren't for the faint-hearted.

For all the eyeball-grabbing long-term performance and the fact they are in the 'peak excitement' phase, these funds find themselves in slopes of disappointment for long stretches. In fact, you'll see three to four-year periods when small-cap funds deliver zero to negative returns (see 'Bubble burst' table). Meaning, if you look beneath their bubbly surface, you'd realise that investing in this universe is a test of patience.

The lure of quick buck
The pull of small-cap funds is undeniable. Understandably so, given their long-term performance. But where investors trip up is when they want to make quick profits. What they fail to realise is that small-cap returns are not linear. In other words, they are not consistent.

Their one- and three-year rolling returns, which means when you buy the fund on any given day of the year and hold it for the next 12-36 months, can attest to that. Based on these metrics over the last ten years, small-cap funds' average returns have been negative 25 per cent and 13 per cent of the time, respectively. Just goes to show that small-caps are for investors willing to wait it out for more than five years. Even the best of funds takes three to four years to give you positive returns in the worst of conditions.

Moral of the story: invest in small-cap funds for the long term (over five years) and if you can stomach long periods of famine.

Mukul Ojha

Suggested watch: How to pick the hottest small-cap fund?