SMALL AND FULL OF POTENTIAL
Investing in small-cap funds could be risky, but they also provide an upside that can be a significant wealth creation strategy
Investing in equity mutual funds is all about choosing the size of businesses to invest in. Very big businesses are regularly in the news for even the uninitiated investor to have heard of them. This may not be true of many businesses that fall in the small-cap segment of the stock markets. Smaller companies tend to have a focused business but have the potential to grow in revenues as well as profit in the long run, compared to many large ones that have a diversified multi-line business. Investors who can stomach risk find investing in small-cap funds as an opportunity to make significant gains.
Small-cap mutual funds, as per the SEBI (Securities and Exchange Board of India) mutual fund classification, are those funds that invest at least 80 per cent of their total assets in small cap companies. According to the SEBI framework, the top 100 stocks by market capitalisation are defined as large-caps; the next 150 are mid-caps; and the rest small-caps. So companies that fall after the 250th position on the list based on market capitalisation are small-cap stocks, which small cap mutual funds predominantly invest in.
➘ WHY SMALL CAP FUNDS?
Investing in equities is about growth and making profits. Large-cap funds tend to invest in companies that have well diversified business structures than smaller firms. They are less exposed to volatility and swings in their revenues and growth from year-to-year. However, smaller businesses have the potential for much faster growth due to their size and the phase of business cycle they are in. Investors who are looking for a faster growth in their investments prefer to invest in these funds as an opportunity within their overall allocation to equities.
If you go by the returns posted by the S&P BSE Small Cap Index and the S&P BSE Sensex over the past four years, there is a
lot that can be understood about how small cap and large-cap companies fare (see Size Matters). The past four years have seen cycles of growth as well as falls on the back of the Covid-19 pandemic, which further provides insights into how large and small companies fare in different market cycles. During market upsides, the returns from smaller companies tend to be much higher than that of the large companies and their fall is equally steeper when markets fall.
➘ ROLE IN PORTFOLIOS
The role of large- or smallcaps in a portfolio is not binary, as even large-cap funds would have some exposure to small-cap stocks in their portfolios. However, adding small-caps in one’s portfolio is a matter of tactical decision in portfolio creation as well as the risks that an investor can take when investing in them. Investors with already well-diversified equity exposure can allocate funds into small-cap mutual funds to diversify based on market capitalisation to give an overall fillip to their portfolio returns.
Investors also need to have patience and the ability to take risks (see Flipside of Small Caps) when adding small-cap funds to their equity allocation. The risks are high, but so is the returns potential when investing in these funds. Moreover, the universe of small-cap funds has many schemes to choose from and each of them follows a different investment process and stock selection. It would do investors good to understand how to select funds to invest, the basis on which they shortlist stocks and their investment methodology with small-cap companies. Likewise, it is not just about stock selection; it is also about increasing and decreasing allocation to sectors and select stocks that impact the performance of mutual fund schemes focusing on the small-cap segment. These funds are suitable for experienced investors, who, depending on their profile, could have a 15-20 per cent allocation to small-caps within the equity component of their investment portfolios. They should also be aware that there is very high risk involved in this category of funds in the quest for high returns.
When choosing a fund in this category, go further into the fund’s portfolio to understand the kind of companies in which it has invested and the way the fund selects stocks. Often, investing in this category calls for mental resilience to stay invested for a decade or more. Investing in these funds through the SIP (systematic investment plan) route exists, but it is also a good tactic to make lump sum investments whenever the market falls and there is an opportunity to ride a growth cycle.
Choose a fund that adopts a robust stock selection mechanism and updates its process of stock selection to align with changing economic conditions. Funds that have a history of having fared well over different market cycles is a plus when shortlisting one to invest in. Fund managers would factor in economic conditions, new government policies and potential that different businesses have to invest accordingly and produce results. Think of a long-term SIP when investing in this category and outsource the process of choosing small businesses that have the potential for wealth creation. ■
A GOOD AND STABLE BUSINESS MODEL RUN BY COMPETENT MANAGEMENT IS THE HALLMARK OF SMALL BUSINESSES THAT FIND THEIR WAY INTO MOST SMALL-CAP FUNDS