By Varun Fatehpuria
Small-cap funds became investors’ favourites during the first half of the year. The S&P BSE 250 Smallcap TRI delivered a positive return of 14.28% year-to-date, while the category as a whole witnessed net inflows of over Rs 17,800 crore until June 2023, according to data from the Association of Mutual Funds in India.
According to the categorisation by the Securities and Exchange Board of India, small-cap stocks are companies ranked 251 and below in terms of market capitalisation. These stocks typically exhibit lower liquidity compared to their large-cap or mid-cap counterparts, making them more prone to extended periods of extreme volatility.
The recent decision by Nippon India Small Cap Fund and Tata Small Cap Fund, with assets under management of over 28,000 crore and4,000 crore respectively, to stop accepting fresh investments highlights the limited opportunities that fund managers see in small-cap stocks in the current market cycle.
Here are a few reasons why investors must exercise caution when investing in small-cap funds:
Higher volatility and risk
Small-cap stocks, by nature, are characterised by higher volatility compared to their large-cap counterparts. Smaller companies are often more sensitive to market conditions, making them prone to wild price fluctuations. So, investors need to be prepared for heightened risk exposure when allocating a portion of their portfolio to small-cap funds.
Limited liquidity
Investors must also recognise that smaller companies often lack the same level of liquidity as large-cap stocks. Buying or selling substantial quantities of small-cap shares can be challenging, potentially leading to higher bid-ask spreads and greater transaction costs. This limited liquidity can make it harder for funds to exit positions swiftly, especially during periods of market stress.
Sector/ company focus
While the small-cap universe is large, most of the funds have concentrated holdings in specific companies and sectors. For instance, many small-cap funds have significant exposure to sectors such as financial services, technology, and healthcare. While these sectors may offer attractive growth prospects, overexposure to a single sector can leave investors vulnerable to sector-specific risks. A sudden downturn in a particular industry can significantly impact the performance of small-cap funds, underscoring the importance of diversification and careful sector allocation.
Expensive valuation
The surge in investor interest over the past few months has driven up the valuation of most of the small-cap companies with mutual fund holdings. The price-to-earnings ratio of Nifty Smallcap 250 with MF holdings is 58 compared to 25 of companies with no institutional exposure. Fund houses run the risk of driving up the valuations and making future returns unattractive if they are forced to deploy higher levels of cash than what is ideal.
While small-cap stocks offer the potential to provide higher returns, they must be evaluated in the context of the current investing environment. By adopting a cautious and informed approach, investors can accordingly mitigate the risks associated with their allocation and generate greater risk-reward on their investments.
The writer is founder & CEO, Daulat
SIZE MATTERS
- Buying or selling substantial quantities of small-cap shares can lead to higher bid-ask spreads and greater transaction costs
- Evaluate them in the context of the current investing environment