5 points to remember before investing in Small-Cap funds

Here are 5 points to remember before investing in Small-Cap funds:

5 points to remember before investing in Small-Cap funds

 

You might have been advised to stay away from small-cap funds, and allocate a major chunk of your assets into large-caps.

If you are an aggressive investor, such a strategy might be unsuitable.

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Unbelievable right…but that’s the fact!

Avoiding small-cap funds can’t be the prudent way to deal with the issue. In fact, such an escape might prevent you from enjoying its magical return-generating potential.

Small-cap funds are one of the means to earn extraordinary returns in the rising markets. The reason lies in its investment strategy which you may find unique vis-a-vis the large-cap funds.

Small-cap funds earn higher returns on account of its incredible underlying holdings.

Small-cap funds allocate 65%-90% of the funds primarily in stocks of small-cap companies. The small-cap stocks are identified by looking at the BSE or NSE indices.

As compared to large-caps, these are high beta stocks which are positioned on a high risk-high return trade-off plane. You may regard high beta stocks as those which are highly sensitive to the market movements.

Take the case of Sundaram SMILE Fund which has a beta of 1.12. It implies that the fund may gain 12% higher than the benchmark in an upmarket. Similarly, the fund may lose 12% more than the benchmark in a down market.

The remaining assets may be spread among mid-cap and large-cap stocks to provide stability to the portfolio. Additionally, to minimize risks, many small-cap funds may diversify across sectors as well.

The fund manager aims to generate excess alpha over and above the chosen benchmark. It is done by selecting the right stocks with optimum diversification. It leads to a capital appreciation in the long run.

To get the most out of small-cap funds, it is necessary to understand its structure. You need to develop a strategy, to make entry and exits at the right time

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Small-cap funds & Market movements: The Analogy

When you want to invest in small-cap funds, you have to know their overall market-related behavior.

Consider a period starting from January 2006 to December 2008. This three year period witnessed a steady rise and a steep fall by the end of the horizon.

If you had invested a SIP of Rs 1000 in a small-cap fund at the beginning of January 2006, you would have ended with a corpus of Rs 27128 by the end of December 2008.

The table illustrates the returns earned during the market crisis of 2006-08.5 points to remember before investing in Small-Cap funds

You can see that the extreme sensitivity of a small-cap fund like Sundaram SMILE fund. Such a thing has caused it to lose more than the benchmark index.

While the broad-based Sensex lost only 2.75%, the BSE Small Cap index lost 40.84%. The small-cap fund gave negative returns of around 24.64% as compared to Sensex.

However, Sundaram SMILE Fund lost lesser as compared to the benchmark.

In this manner, small-cap funds tend to erode fund values during a slump.

Now, consider the other period starting from January 2008 to December 2010. It can be called as a recovery phase when markets began rising.

An SIP of Rs 1000 in a small-cap fund would have fetched you a corpus of Rs 53892 by the end of the years.

The table illustrates the returns earned during the market rebound.

smallcapstrats

While the broad-based Sensex gained only 16.21%, the BSE Small Cap index lost -4.48%. The small-cap fund gave positive absolute returns of around 49.70% as compared to Sensex.

Sundaram SMILE Fund not only recovered the losses but also gave higher returns as compared to the benchmark.

In this manner, small-cap funds tend to beat the benchmark during a market rally.

Strategies for investing in Small-cap funds

Patience

Small-cap funds demand a lot of emotional composure from your end. You need to moderate your behavior throughout the investment horizon.

Any impulsive decision may jeopardize your portfolio returns. It won’t take long to erode the gains made by your portfolio owing to faulty switches and hurried redemptions.

You need to be a lot more patient to take a holistic view of the situation; and to make informed choices.

Get used to highly volatile fund NAVs on account of turbulent markets.

Fund Composition

The fund composition makes a lot of difference to your final returns. You need to understand the underlying psyche of the fund manager that goes into stock selection.

Small-cap funds keep looking for companies which have a hidden potential to be a multi-bagger one day. The choice of stocks is endless. However, the risk of incorporating fancy stocks is equally high.

While investing in small-cap funds, give an in-depth look at the portfolio holdings. Ideally, the fund should not be composed of stocks which lack growth potential.

One of the ways to ascertain the fund manager accuracy lies in portfolio turnover ratio. A turnover ratio of less than 30% would be good to go. You can be assured that your fund manager knows what he buys.

You can be relaxed that he’s confident about the calls he takes and is less likely to lose money on account of faulty portfolio composition.

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Rebalancing the Portfolio

Keeping your asset allocations untouched for long can be disastrous. Portfolio rebalancing is the key to gain advantage out of small-cap funds.

An “invest and forget strategy” might not be of much use in this situation. You need to play around with your small-cap fund allocations according to the market scenario.

If you hold a small-cap fund over and above the core portfolio; you might reduce the allocation during a bear run.

In case of a portfolio composed only of small-cap funds, during downturns, you might consider moving allocations from the loss-making funds to the relatively stable ones.

Small-cap funds, thus, call for a tactical allocation as opposed to a passive investing.

Also read: How to rebalance mutual fund portfolio

Investment Horizon

Being an equity fund, small-cap funds require you to stay invested for a long-term. You may think of small-cap fund for an investment horizon of at least 7-10 years.

The basic premise here is to let the fund complete the full cycle.

Usually, you need to invest when the fund has experienced a fall. At that point, you might grab units at cheaper NAVs. When the fund rises afterward, you can expect it is giving returns in line with expectations.

Timing the market could help in making right entry and exit as regards small-cap funds.

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Investment objectives

While investing in small-cap funds, your investment objectives can be a guiding factor. Make sure your financial goals are in line with the fund objectives.

Any deviations might cause unnecessary anxiety and unplanned exits. It happens at the time of heightened volatility.

Before investing, you need to be clear about what you want. In this way, you can make the right choice and stick to it.

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