Small Cap Mutual Funds: How To Cash In With Caution

Small-cap funds have delivered strong returns. However, given its volatility, investing heavily in small caps can be risky. Here’s how you can approach it.

 market rally

Small-cap funds have hit a purple patch in recent times, with more than 31% return during one year. This category of mutual funds has generated over 24% return in five years and 23.7% in ten years. These facts alone would impress investors, who might be tempted to increase their investments in small-cap funds. However, cutting corners is not advised during investment. Let's find out if you should invest aggressively in small-cap funds.

  • Small-cap funds have posted strong returns of over 31% in recent years.
  • Short-term volatility is a known feature of small-cap funds.

  • More than 25% of investment in small-cap funds should be avoided.

  • A balanced investment in short-cap funds limits your risk exposure.

Also Read: Should You Invest In Small Cap Mutual Funds In 2023? How Good Is Quant Small Cap Mutual Fund?

Too Good By Half

When on a good run, small-cap stocks outperform mid-cap and large-cap stocks. However, they can be highly volatile in the short run. In a study of over 18 years of small-cap returns data, it was noted that the worst decline in small-cap funds in a year was an alarming 61%. Small caps are not ideal for short-term investment. However, the returns become less volatile over the long term. For instance, the worst three-year decline noted in the above study was 16.4% and a tolerable 2.9% in five years.

If you look at the performance of individual small-cap stocks over a long period, you can see mixed results from this category. In the last 23 years, 29% of small-cap stocks slipped into the micro-cap category. Only 13% of these stocks have gone on to become mid or large-caps.

How Should You Approach Small Caps?

Given the high short-term volatility and chances of failures of small-cap stocks, it would be unwise to invest a lot in these companies, be it through mutual funds or equity investments. 

  • If you are a conservative investor with little to no risk appetite, you should allocate a small portion of your investment in blue chips, but avoid small caps completely. 

  • For someone with a moderate risk appetite, a small cap investment of 20 to 25% should be the maximum limit.

  • Aggressive investors with larger allocations in small-cap funds must look to rebalance their investment portfolio in the long run. Investors with long-term Systematic Investment Plans (SIP) in small-caps may continue their contribution. However, they should look at the fund appreciation and rebalance the portfolio back to their desired asset class proportions.

Conclusion

One of the key takeaways on small caps is to select the fund scheme very carefully. You must also have an upper limit on your small-cap investment, which can be maintained through regular portfolio rebalancing. And not to mention, keep an eye regularly on the volatility within the category. 

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Also Read: Top Small-Cap And Midcap Stocks Where Mutual Funds Increased Holdings In 2023

 

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas.

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