Investing in small cap funds? Keep these critical points in mind

By: |
June 22, 2021 11:19 AM

If you are planning to invest in small-cap funds, here are a few tips that could help you maximise investment benefits.

Three key strategies that investors must know are - Aggressive Hybrid Funds, Balanced Advantage Fund/ Dynamic Asset Allocation Funds, and Equity Savings Funds.

Higher returns on investments play a significant role in achieving wealth maximisation in the long term. However, higher returns come with higher risks too. In the current market situation, intelligent investing in small-cap equity mutual funds could generate phenomenal returns if you know how to minimise the risks. Small-cap funds follow the strategy of investing in the shares of publicly-traded companies that are not among the top 250 companies in terms of full market capitalisation. The list could include micro-cap companies to those with about $1 billion market capitalisation.

So, if you’re planning to invest in small-cap funds, here are a few tips that could help you maximise investment benefits. But before that, let’s dig deeper to understand the current trends.

So, why are small-cap funds hot favourite in the current market?

In the last one year, some of the top-performing small-cap mutual funds have offered returns over 100%. The returns of small-cap funds have been significantly higher than other categories like mid and large-cap funds during the past few months. According to data from Value Research on June 18, 2021, small cup funds have fetched category returns of 105.31% in the last one year, compared to 57.87% for large-cap funds and 78.65% for mid-cap funds during the same period. The data also shows that the 3-year category returns for small caps, large caps and mid-caps have been 13.94%, 13.15% and 14.47%, respectively.

These exaggerated returns are due to the market bouncing back strongly to new heights after a major crash in the early months of 2020. The crash saw the BSE Small Cap Index fall from the 14,900 levels to around 8,700. By August, the index had returned to its pre-crash level and continued to grow exponentially, passing 25,000 in January 2021. Even if you look past the recovery, the index has earned around 60% on its pre-crash levels in around 15 months.

Now, let’s focus on another data set. According to data on AMFI on June 18, 2021, here are a few small-cap funds that have offered some of the highest annualised returns in the last 1 year.

As shown in the table, these small-cap funds returned a whopping 114.7% to 186.1%, assuming a lump sum investment was made a year back. However, if you notice the 3-year annualised returns of these mid-cap funds, the returns come down to 18.5% to 30.5%. There are other small-cap funds whose 3-year annualised returns are much lower despite generating extremely high returns in the last one year.

The point being, the returns of small-cap funds can be extremely volatile in the short term, and they may not deliver the same level of returns in the long term. Also, past performance should not be misconstrued to translate into a similar performance in the future.

If you invest carefully, small-cap funds can offer huge opportunities to maximise your wealth and play a critical role in your journey to achieve your financial goals in time. Here are some important tips that can be helpful to you when you plan to invest in small-cap funds.

Best investment practices while investing in a small-cap fund

Small-cap funds usually react sharply to stock market movements making them highly volatile compared to large-cap funds. Now suppose you invest a lump sum amount at the peak of the market. In that case, there are chances your portfolio value may go negative when the market falls. On the other hand, due to high volatility, small-cap funds offer an excellent opportunity to grab the benefit of rupee cost averaging by investing through systematic investment plan (SIP) mode. You can also make an additional investment when the market is significantly lower than the initial level in the long term; however, you can continue with a fixed SIP when the market rises.

There are several small-cap funds present in the market, but not all of them have given the same level of returns during the same period. It shows that you should not put your entire money into a single fund because your attached goals might get seriously impacted if that fund underperforms. While small-cap funds can give you phenomenal returns, you’ll be well-advised never to lose sight of the fact that they can be highly risky at the same time.

So, try to keep a low exposure into a small-cap fund to avoid the chances of losses. The best investment technique would be to diversify your investments optimally into multiple top-rated small-cap funds, alongside other investments across various other mutual fund categories and asset classes in line with your returns expectations, risk appetite and liquidity requirements.

(The writer is CEO, BankBazaar.com)

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