Investment mantra: How much should you allocate to small-cap funds?

Small-cap funds are a superb choice for taking exposure to small-caps and much better (for common investors) than trying to pick small-cap stocks directly.
Small-cap funds are a superb choice for taking exposure to small-caps and much better (for common investors) than trying to pick small-cap stocks directly.

Summary

  • Let’s remember that even though small-cap funds seem to offer the ‘potential’ for significantly higher future returns than, say, large-caps, they also come with much higher risks compared to large-caps or even mid-caps.

Recently I was talking to my uncle who is in his late forties. And as always happens with me (being in the financial advisory space), the topic of investments came up. He said that his investments had done phenomenally well over the last few years. On enquiring further, I came to know that his mutual fund portfolio was made up of three small-cap funds and one mid-cap fund. I was curious about the absence of any schemes from large-cap or large-cap oriented categories. But very soon, his recency bias due to the stellar rally in small-caps was evident. What was a little disturbing for me was to hear that he was looking at further increasing allocation to small-caps by moving funds from debt to small-cap funds!

To be fair, staying in small-cap (funds) over the recent past has worked very well for investors. Here is a small aggregate data (of small-cap funds that are at least three years old) that proves this (see graphic).

Irrespective of whether you look at the data of the last one, two or three years data, even the worst small-cap funds have comfortably beaten returns given by large-cap indices like Nifyt50/100 and also large-midcap indices like Nifty200.

And this return profile of the recent past (more specifically the run-up after the pandemic bottom of 2020) has more and more people getting more aggressive with small-caps. New entrants in markets won’t acknowledge (or understand) but mean reversion is still a thing in markets. And given the structurally volatile nature of small-caps, at times, the reversion in this space can be deep and painful. Ask those who have been investing for decades and they will tell you.

This had me thinking. What is the right allocation to have to small-cap funds in a mutual fund (MF) portfolio?

Of course, the answer will vary for different individuals. But still, should one have some guiding guard rails to control the exposure? I think that is required.

Unless you are a professional investor or really have some solid insight about the space, you have no reason to be heavy on small-cap at any time. And this I say for common everyday investors.

In my unsolicited view, if you belong to the balanced or moderately aggressive investors category, then I suggest capping the exposure to small-caps to a maximum of 25-30% of the overall equity exposure.

Many of you may not agree with this view, and more so with recent data to help your case. But let’s remember that even though small-cap funds seem to offer the ‘potential’ for significantly higher future returns than, say, large-caps, they also come with much higher risks compared to large-caps or even mid-caps.

Small-cap funds are a superb choice for taking exposure to small-caps and much better (for common investors) than trying to pick small-cap stocks directly. But don’t be too greedy looking at the recent outperformance and limit yourself to 25-30% in this space. And be willing to remain invested for at least 5-7 years (longer would be better). And what if you have a lower risk appetite and consider yourself to be a conservative sort of investor? In that case, just skip small-cap funds. You don’t need them. The small equity exposure you need is best managed via large-cap funds or flexi-cap funds. That’s it.

I don’t have a crystal ball to tell you whether the ongoing party of small-caps (even after the recent small correction) is over or will still go on. But given what the space has delivered in recent times, it is definitely good to be cautious. If nothing else, I would leave you with one takeaway (that I gave earlier too), do not let your small-cap exposure go beyond 30%. In roaring bull markets, you will be tempted to do so. But it’s good to rebalance and bring it back to saner levels. And if you are still not convinced and still have a small-cap heavy portfolio, I strongly suggest you go and talk to a good investment adviser.

Dev Ashish is a registered investment adviser and founder of Stable Investor

(The views expressed above should not be considered professional investment advice or advertisement or otherwise.)

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