Small Caps Surpass Large Caps On Folios As Investors Flock To Mutual Funds

Lakhs of Indian retail investors are piling into actively managed small-cap mutual fund schemes as they look to ride the ongoing rally. But given the run-up in quite a few of these schemes, advisers are cautioning investors to opt for a staggered approach to investing.

For the first time ever, the number of folios in small-cap schemes overtook those in similarly managed large- and flexi-cap funds in August, according to AMFI data. The number of individual folios in small-cap schemes is now only second to those in equity-linked savings schemes, a favourite because of the benefits it provides to taxpayers.

The number of folios in small-cap schemes rose by over 55% since August last year, the largest increase by far in any scheme category.

The increase in the number of folios has been accompanied by higher inflows into these schemes.

August marked the 30th consecutive month of net inflows into small-cap schemes, according to data provided by the Association of Mutual Funds in India. In this calendar year, these funds have seen inflows of Rs 26,000 crore.

During this time, mid-cap funds received Rs 14,400 crore, while large-cap funds saw net outflows of Rs 3,200 crore.

"A lot of investors are biased by the recent surge among small-cap stocks, looking to replicate the returns through mutual funds," Prableen Bajpai, founder of FinFix Research and Analytics Pvt., told BQ Prime.

However, despite the continued investor interest in the small-cap segment, mutual funds failed to outperform against their benchmark indices this year.

The Nifty Smallcap 250—the National Stock Exchange's benchmark index for the small-cap basket—rose by over 39%, beating gains in the Nifty 50, which rose 15.9% since the beginning of the financial year.

However, funds covering the same segment of the market found it difficult to keep up.

Since the beginning of the financial year, no scheme outperformed its respective benchmark index, according to AMFI data.

While small-cap funds have historically beaten the benchmark, fund managers are finding it difficult to replicate the results while keeping up with the recent rally.

The factors for the underperformance could be heated valuations in the segment as well as the limited free-float among small-cap stocks.

With the record amount of inflows in the segment, multiple fund houses have suspended the option to invest via the lump-sum route. The first to do so was Tata Mutual Fund, which stopped investments other than via systematic investment plans and systematic transfer plans from July 1.

India's largest small-cap fund—the Nippon India Small Cap Fund—followed suit implementing the same measure, with effect from July 7.

"The step is warranted considering the recent sharp rally in the small-cap space and increased investor participation through high-ticket investments, which would be in the best interest of existing unitholders and appropriate for incremental investments," the fund house said.

A key sector that also benefited from the rally in this segment was the defence sector, where stocks rose by over 173% during the financial year-to-date period.

On June 9, HDFC Mutual Fund announced suspension of investments via lump-sum method in its defence fund, with effect from June 12.

"Volatility in the market is a natural phenomenon," said Hemant Rustagi, chief executive officer at Wiseinvest, referring to the recent underperformance of small-cap funds.

Long-term investors have less to worry about as opposed to those who intend to make lump-sum investments over a shorter period to capitalise on market momentum, he said.

According to Bajpai, there's still potential for small-cap funds. "Fund managers don't have the compulsion of increasing weight of funds, which went up without fundamentals to support it," she said. There are opportunities for fund managers to find stocks that are good but haven't run-up in this manner, she said.

Kshitiz Mahajan, managing partner at Complete Circle Wealth Solutions, advised to have a goal of making "stress-free returns". Depending on risk appetite, he said the exposure to small caps shouldn't be more than 10% of the equity portfolio.

For those who have a conservative approach, flexi and multi-cap funds are the ideal bet, he said. For those with a moderate risk appetite, around 5–7% allocation of the equity portfolio can be invested in small-cap funds, according to Mahajan.

"If one has an aggressive approach, 10% of allocation would make sense. However, these investments must be made over a longer term, such as that of over 10 years."

Kalpen Parekh, chief executive officer at DSP Mutual Fund said that any investment done on the basis of past returns actually has been harmful. "Either you moderate your expectations and be prepared if there's volatility, don't panic that time," Parekh said. "And if you have to panic when prices fall, you'd rather panic early."

He said some profit-booking may be a viable option for those with a weaker risk appetite.