Retail investors are increasingly betting on small-cap funds as most of them have delivered over 25% annualised returns over the past three years. While some allocation in small-cap funds does work for investors, these funds are volatile and can go through bigger swings during difficult market conditions.

The risk appetite of the investor must be high so that he can remain calm during volatility and the holding period should be longer as compared with large-cap funds as the companies in which small-cap funds invest may take more time to unlock their real potential.

As a general rule, Chandraprakash Padiyar senior fund manager, Tata Mutual Fund, says that small-cap is a segment for stock picking with plenty of choice of businesses to choose from. “One needs to be choosy and selective to win in this segment,” he says and adds that with the current world view, it looks like India and, specifically the small-cap segment of the market, may be poised to benefit over the foreseeable future and hence the interest from investors.

Take a blended approach

Looking at small-cap funds from a long-term wealth creation perspective can work better for investors. However, as small-cap funds invest in companies that are evolving, they can be volatile. Harshad Chetanwala, co-founder, MyWealthGrowth.com, says the key is to remain invested in good small-cap funds and not exit just because the returns on these funds have been low for a shorter period. “As going overboard on small-cap funds can have an impact on the overall portfolio, a blended approach will be always good during good and tough times in the market,” he says.

On the risk-return trade-off, investors of small-caps must be watchful of volatility. However, there’s a very vast universe of stocks in this space since all stocks beyond the 250th rank in market capitalisation would be small-cap. Kaizad Hozdar, investment advisor, TrustPlutus Wealth, says a lot of detailed study is required to find the proverbial pearls from this vast ocean. “In addition, one also runs the risk of management integrity in this space,” he says.

On the other hand, the mid-cap space has just 150 names and there are a number of businesses which are very dominant but continue to remain in the mid-cap segment due to the limited size of the overall industry. Management quality too is a notch higher here. In fact, over the past 10 years the Nifty Midcap100 (14.5% CAGR) has outperformed the Nifty Smallcap100 (10.5% CAGR) by a decent margin. “Hence it is apparent that although the small-cap space is a riskier hunting ground, this risk is not being adequately compensated by higher returns. Hence an investor would be better off having a higher allocation to mid-cap as compared to small-cap funds,” says Hozdar.

Tick all the boxes

Revenues and profits of small-cap companies tend to fluctuate more than those of mid or large-cap companies due to lower ability to withstand major market or economic downturns such as a sharp slowdown in growth or a jump in interest rates. But the potential for growth in small-cap is also greater than mid-cap due to a lower base of revenues and profits. Due to these factors, share prices of small-cap companies tend to be more volatile.

Also read: New Warren Buffet Quotes 2023: 10 Lessons For Saving, Investment, Money and Success in Life

Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says, the allocation for small-caps in a portfolio is critical and should be based on one’s investment horizon and risk appetite. “For investors with a low to moderate risk appetite and a medium-term

horizon (three to five years), the allocation to small-caps can be limited to around 5%. Investors with a longer horizon and higher risk appetite can maintain a higher allocation,” he says.

Valuations also play a key role in driving performance of small-cap stocks. After periods of strong performance in small-caps when valuations are rich (above long term averages), one should be cautious and maintain an underweight position. “Given the potential volatility in small-caps, one can consider two to three small-cap funds while constructing a portfolio, rather than investing in a single fund,” says Kapadia.

Before investing in any such fund, individuals must aso see that the majority of the portfolio

companies have decent management quality and bandwidth. It is important to have companies which have exhibited quality growth consistently without compromising on margins and balance sheet strength and these companies should belong to industries which have a long runway of growth ahead.

Also read: Investing strategy: How to smartly allocate your assets in 2023

As the small-cap space has lower quality of disclosures and publicly available information, the portfolio should preferably be a diversified one as compared to a high conviction portfolio of concentrated bets. “The fund should have had lower drawdowns versus the benchmark in years when the small-cap space was under pressure. Lastly, it would be prudent to go with a small-cap fund where the fund manager has had a long tenure managing the fund,” says Hozdar.