Equity Investing: Booking profits in small-cap funds?

With an increasingly volatile market due to the geopolitical tensions, individual investors are now opting to cash out of small-cap stocks as this segment has rallied significantly in the past two years with returns more than that of large cap stocks. In the last one year, the Nifty Smallcap 250 has fetched returns of 27% as compared with 12% for the benchmark Nifty 50.

Higher short-term returns from small –cap funds even attracted a lot of retail investors into this category through mutual funds in the last one year. In February this year, the small-cap category reported net inflows of Rs 1,430 crore as compared to net outflows of `452 crore in the same month last year, data from Association of Mutual Funds in India show.

While small-cap funds offer the potential for higher returns during an economic recovery, it undergoes higher declines during market downturns. In fact, during 2014-17 small caps outperformed large caps when the cycle was in favour. The period between 2018 till the Covid crash shows the sharp decline in small caps.

Should you book profits from small-caps?

Small cap segment does well during an economic recovery. If the economic recovery pans out as expected over the next two to three years, the small cap segment can continue to do well. Arun Kumar, head, Research, FundsIndia, says while valuations are definitely not cheap, barring a few select pockets, there are no signs of broad-based extreme overvaluations and nowhere near the expensive valuations seen at the end of 2017. “Investors with a high-risk appetite can stick to their long-term intended small-cap allocation. We are neither underweight or overweight on small caps and recommend a neutral allocation at this juncture,” he says.

Mitul Shah, head of research, Reliance Securities, says as volatility is likely to continue in the near term, profit booking in a few small-cap stocks trading at higher valuations is advisable. “An investor should hold quality large caps and a trading strategy can be adopted in select small-cap stocks that have corrected sharply and are available at an attractive valuation. The strategy should be to add attractively valued quality small-cap stocks,” he says.

Investing in small cap mutual funds

Investing in small-cap mutual funds should be done from a long-term perspective. These funds always carry additional risk as the money from these funds is invested in companies that are at initial or nascent stage. These companies could take more time to unlock their potential and at the same time will be more volatile as the liquidity in the small companies is limited.

Harshad Chetanwala, co-founder, MyWealthGrowth.com, says one can try to restrict the allocation to small -cap funds to around 5% of the overall portfolio. “Be more cautious before investing additional amounts in small-cap funds. Even though the NAV of the small funds would have got impacted due to present market consolidation, these funds will be more volatile in present times if the crisis persists,” he cautions.

In the mid- and small-cap space, it is extremely important to understand different aspects of the company before investing. As small-cap funds always carry additional risk, individual investors can consider large-cap, mid-cap and flexi-cap funds to invest across market capitalisation.

Mehta says one of the best ways to look at the overall portfolio is to check the portfolio’s market capitalisation. “Usually, if you have invested in large and mid -cap funds and flexi-cap funds, there is a high possibility that you already have some allocation in small-cap stocks as well. This can be followed throughout the time and it works particularly well during volatile markets,” he says.

Aggressive investors willing to put up with higher volatility and seeking higher returns over the long term can invest a small portion through small-cap mutual funds. Kumar advises investors to keep the allocation to less than 10% of the overall equity exposure and stagger investment across three to six months instead of lump sum investments and stay invested for at least for seven years.