Scalding small caps

With small-cap valuations getting even more expensive than those of blue chips, investors must exercise caution with small-cap funds

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With a trailing three-year CAGR of over 29 per cent and five-year CAGR of 30 per cent, the small-cap equity-fund category is currently riding a wave of popularity thanks to the runaway bull market. SIP returns for these periods are impressive, too, at 25 per cent for three years and 30 per cent for five years. But caution should be the watchword for investors tempted to rush into this category. For one, small-cap stocks are most vulnerable to any market correction at this juncture. Small-cap index valuations are currently at a steep premium to those of blue chips, traditionally a sign of an overheated market. The average portfolio P/E of funds in this category is more moderate, at 22 times, but that's not exactly cheap from a historical context.

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Two, some small-cap equity funds which have flexibility in their mandate have been raising their allocations to large- and mid-cap stocks while reducing weights to small caps. Funds that don't have such flexibility have taken to restricting new investments, especially by way of lump sums into their funds. These are strong signals that fund managers now find fewer deployment opportunities in this space.

Investors keen to benefit from the higher return potential of small caps can continue to invest through the SIP route. They, however, need to note that given the high valuations currently, committing less than five-year money to this category may not pay off.

The small-cap equity category managed Rs 27643 crore as of end March 2017.

We recommend the following small-cap funds:

DSPBR Micro Cap Fund

Franklin India Smaller Companies Fund

L&T Midcap Fund

Reliance Small Cap Fund

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