Small Cap Index Near an All-time High: Should You Rejoice or Worry?

April 25, 2024 Mutual Fund

The small-cap investing mania seems to be unceasing. The S&P BSE SmallCap Index, after a brief correction, is near its all-time high (of 46,821.39 points, made on February 7, 2024).

It appears that the froth building in the small-cap segment (as highlighted by SEBI earlier this year) and the stress test data of Small Cap Funds are not concerning investors.

The latest stress test results as per March end portfolio data reveal that Small Cap Funds would take, on average, around 13.7 days to liquidate 50% of their portfolio, slightly lower than the previous results of 14 days.

However, it is important to note that during periods of high volatility and market turmoil — when many investors would sell in panic — small-caps could fall more compared to mid-caps and large-caps. In such times, the risk increases, and so does the number of days to liquidate a small-cap portfolio.

Hence, it would be imprudent to bet heavily on small-caps. In March 2024, Small Cap Funds for the first time since September 2021, reported net outflows worth Rs 94.17 crore. But in contrast, the AMFI data showed that a net of 3.6 lakh folios were added in the Small Cap Fund category.

Graph 1: Small Cap Mutual Funds Have Sparked the Interest of Investors

Data as of March 2024
In the case of inflows in sub-categories of equity funds, the segment-wise data reported by AMFI is from April 2019 onwards.
(Source: AMFI, data collated by PersonalFN Research) 

Perhaps the handsome returns (across time periods) clocked by Small Cap Funds over the last couple of years, have been a point of attraction for investors.

Table 1: Performance of Small Cap Mutual Funds

Data as of April 23, 2024
The list of funds cited here is not exhaustive.
Returns expressed are rolling returns in %. calculated using the Direct Plan-Growth option.
Standard Deviation indicates Total Risk and Sharpe Ratio measures the Risk-Adjusted Return. They are calculated over 3 years assuming a risk-free rate of 6% p.a.
*Please note, that this table represents past performance. Past performance is not an indicator of future returns.
The securities quoted are for illustration only and are not recommendatory.
Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, data collated by PersonalFN Research) 

As seen in the table above, several Small Cap Funds, managed to outperform the benchmark index, thus creating alpha returns for investors. On a 3-year return, 11 out of 22 schemes outperformed their benchmark, while over 5 years, 16 schemes outperformed.

The overall risk-adjusted returns (as denoted by the Sharpe Ratio and Sortino Ratio) have also been wanting. In other words, many Small Cap Funds have adequately compensated investors on a risk-adjusted basis.

However, the question remains: Can Small Cap Funds continue to generate attractive risk-adjusted returns in the future?

The S&P BSE SmallCap Index after plunging for a brief period in March 2024, has recovered remarkably so far in April. As seen in the graph below, small-caps have accelerated in comparison to the mid-caps and large-caps.

Graph 2: S&P SmallCap Index Zooming Ahead of Counterparts

Data as of April 23, 2024
Base = Rs 10,000
Past performance is not an indicator of future returns.
(Source: ACE MF, data collated by PersonalFN Research) 

The valuations in the small-cap (and mid-caps) seem relatively expensive than large caps. The Price-to-Equity (PE) ratio of the bellwether, S&P BSE Sensex is at 24.7x, while of the S&P SmallCap Index is at 33.4x — that’s a relative premium of 35.1% as of April 23, 2024.

Graph 3: Smallcap Index-to-Sensex Ratio Is at a Peak

Data as of April 23, 2024
(Source: ACE MF, data collated by PersonalFN Research) 

The S&P BSE Smallcap to Sensex ratio, another determinant of valuations in the small-cap segment, currently stands over 0.63 versus a long-term median of 0.45, as of April 23, 2024. These levels were last seen in 2018, just before the mid and small-cap crash of 2018-19.

Thus, the margin of safety at these elevated levels of the SmallCap Index seems narrow. While you may rejoice if your Small Cap Funds have delivered handsome returns, it would be unwise to get excited and invest more in small caps expecting super-normal returns.

As you may know, the equity markets move in cycles: a bull phase is followed by corrections or bear phases, and vice versa. At present, the following are the key risks that could spoil the party on Dalal Street:

– Intensifying geopolitical tensions

– Potential geoeconomic fragmentation

– Possibility of supply chain disruption

– Increasing commodity prices, mainly food and fuel

– Risk to inflation trajectory, resulting in central banks pushing back rate cuts

– The outcome of the general elections in India turning to be other than what was expected

– And a possible slowdown in economic growth

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If things do not pan out as expected, the Indian equity markets may correct. In such a case, the small-cap segment may be more vulnerable. Simply put, they may tumble more than mid-caps and large-caps.

Table 2: Performance of Small Cap Funds During the Bear Phase of Global Financial Crisis and the Ensuing Bull Phase

Returns expressed are point-to-point in %. calculated using the Direct Plan-Growth option.
Returns over 1-year are compounded annualised.
*Please note, that this table represents past performance. Past performance is not an indicator of future returns.The securities quoted are for illustration only and are not recommendatory.
Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, data collated by PersonalFN Research) 

History reveals that during the bear phase of the Indian equity markets during the Global Financial Crisis of 2008-09, the average returns of Small Cap Funds (total 7 in numbers then) plunged more than Mid Cap Funds and Large Cap Funds (See Table 2).

Table 3: Performance of Small Cap Funds During the Bear Phase of the COVID-19 Pandemic and the Ensuing Bull Phase

Returns expressed are point-to-point in %. calculated using the Direct Plan-Growth option.
Returns over 1-year are compounded annualised.
*Please note, that this table represents past performance. Past performance is not an indicator of future returns.The securities quoted are for illustration only and are not recommendatory.
Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, data collated by PersonalFN Research) 

Similarly, in the brief setback of the COVID-19 pandemic from January 14, 2020, to March 23, 2020, as seen in Table 3, Small Cap Funds, on an average, took a hit.

The point is that while you may be elated with the returns made by your Small Cap Funds, don’t ignore the downside risk. Avoid getting carried away by irrational exuberance and investing excessively in Small Cap Funds. Keep in mind that for every level of return you seek, there is a level of risk. In the case of Small Cap Funds, the risk is very high; they are not for the fainthearted.

The Approach to Follow

Follow a Core & Satellite investment strategy, which is followed by some of the most successful equity investors around the world.

The term ‘Core’ refers to more stable and long-term holdings. Typically, these should be around 65%-70% of the equity mutual fund portfolio and comprise some of the best Large Cap Funds, Flexi Cap Funds/Multi-cap Funds, and Value/Contra Funds. They could help potentially multiply your wealth with stability but make you keep an investment horizon of at least 5 years.

The term ‘Satellite’, on the other hand, refers to the strategic portion that would help push up the overall returns of the portfolio with relatively high risk. This portion of the portfolio could comprise around 30%-35% of the equity portion and a couple of best Mid-cap Funds (max 2), and if you have a very high-risk appetite, then one of the best Small Cap Funds.

Small Cap Funds should not be more than 10-15% of the entire equity portfolio, and you ought to keep a longer time horizon of 7 to 10 years when investing in them to alleviate the downside risk if the broader markets correct in the near term (due to the macroeconomic and geopolitical uncertainties in play).

Prefer small-cap funds that follow robust investment processes and systems, pay close attention to liquidity, market capitalisation, and how optimally diversified the portfolio is, and whether the portfolio is held with conviction. Ensure that you are choosing a Small Cap Fund/s that is true to its label.

[Read: 5 Best Small Cap Funds for 2024]

For tactical allocation to equity, debt, and gold (the three key asset classes), also have some exposure to a Multi-Asset Allocation Fund.

[Read: 3 Best Multi Asset Allocation Funds for 2024]

By following a sensible approach and wisely structuring your mutual fund portfolio (based on your age, risk profile, broader investing objective, the financial goal/s you are addressing, and investment time horizon), you would potentially earn optimal risk-adjusted returns, enabling you to accomplish your envisioned financial goals.

Take care to ensure that you follow a sensible asset allocation and your portfolio is well-diversified in the year 2024 and beyond. Be a thoughtful investor.

When in doubt, don’t hesitate to reach out to a SEBI Registered Investment Advisor.

Happy Investing!

This article first appeared on PersonalFN here