Will Small Cap Mutual Funds Continue to Outshine in 2024?

December 27, 2023 Mutual Fund

After a turbulent start, the Indian equity market created history in the calendar year 2023 by scaling multiple peaks. The Nifty 50 surpassed the key milestone of 20,000 while the S&P BSE Sensex surpassed 70,000 in December 2023, gaining 17.9% and 16.9%, respectively, on a YTD basis (as of December 22, 2023).

However, it was the small-cap segment that emerged as the winner in 2023. The Nifty Smallcap 250 index outperformed its mid and large-cap peers and gained 45.5% during the year. The Small Cap Mutual Fund category registered growth of around 41% on average over the same period. Mahindra Manulife Small Cap Fund, Bandhan Small Cap Fund, ITI Small Cap Fund, and Franklin India Smaller Cos Fund were the category toppers during this period, generating absolute returns of over 50%.

Favourable factors such as optimism surrounding the country’s macroeconomic fundamentals and heavy participation by retail investors overshadowed headwinds such as the Russia-Ukraine war, Israel-Hamas war, rising crude oil prices, US Federal Reserve’s hawkish stance, weak external demand, and erratic monsoon.

Small-cap stocks witnessed a stellar rally in 2023

Data as of December 22, 2023
(Source: ACE MF, data collated by PersonalFN)

Historical data suggests that during phases of prolonged bull run and robust economic growth, the small-cap segment tends to outshine their larger counterparts.

The exceptional performance of small-cap stocks resulted in a surge in tide in favour of Small Cap Mutual Funds. The category garnered Rs 37,179 crore in CY 2023, as per the AMFI data. Meanwhile, the Large Cap Mutual Fund category registered outflows worth Rs 2,687 crore.

Can the small-cap euphoria continue in 2024 — Is it time to move away from Small Cap Mutual Funds?

India continues to be one of the fastest-growing economies in the world, supported by government spending and robust performance in manufacturing and infrastructure sectors. The RBI expects that going ahead, private consumption may gain support from gradual improvement in rural demand, strengthening of manufacturing activity, and continued buoyancy in services. This can provide a fillip to the market. It further added that the healthy twin balance sheets of banks and corporates, high capacity utilisation, continuing business optimism, and government’s thrust on infrastructure spending may propel private sector capex.

These factors bode well for the equities and therefore, the Indian equity market is anticipated to maintain its positive trajectory in 2024.

That said, global growth and interest rate uncertainties, geopolitical tensions, and any potential unlikely outcome of the general elections in India may play spoilsport.

[Read: Want to Invest in Small cap Funds? Manage the Risk and Reward Well]

Thus, while the exuberance may continue for some more time it is important to tread with caution, especially when it comes to investing in Small Cap Mutual Funds. This is because amid the sharp rally, the valuation in the small-cap segment appears frothy.

Notably, the S&P BSE Smallcap to Sensex ratio, a determinant of valuations in the small-cap segment, currently stands at 0.6 versus a long-term median of 0.43. This level was last seen in 2018, just before the mid and small-cap crash of 2018-19. Additionally, most good quality small-cap stocks are trading near their lifetime high valuations.

Smallcap to Sensex ratio is at a peak

Data as of December 22, 2023
(Source: ACE MF, data collated by PersonalFN)

Another important indicator of valuations, the Buffet indicator, which takes into account the total market cap to GDP ratio, is showing signs that the market may have priced itself well ahead of the curve. The Buffet indicator is currently at 104.5%, placing it in the modestly overvalued zone. Any further rise in the market can place it in a significantly overvalued zone. Thus, the margin of safety has narrowed which makes it vital to avoid getting carried away by irrational exuberance or expecting the market to generate similar returns in the future as well.

Notably, an unprecedented amount of money has, and continues to chase, the Small Cap Mutual Fund space. But many small-cap stocks do not have the capacity to handle exceptionally large trading volumes. In other words, small-cap stocks can face liquidity constraints. Small Cap Mutual Funds also find it challenging to invest the inflows worth crores they are getting each month. Not surprisingly, some mutual fund houses have restricted fresh inflows into their small-cap schemes.

[Read: Why are Mutual Fund Houses Pausing or Limiting Investments in Small Cap Funds]

It is also important to note that the equity markets are cyclical in nature – peaks are followed by downfalls, and vice versa. Small caps are usually not resilient during bearish market phases and tend to witness higher downside risk compared to mid and large caps.

What should be the investment strategy when investing in Small Cap Mutual Funds?

Small Cap Mutual Funds are high risk – high return investment avenue. Thus, these schemes are only suitable for individuals who have a very high risk appetite to handle sharp market volatility and an investment horizon of 7-10 years. Conservative investors and those with a short to medium-term investment horizon should stay clear of Small Cap Mutual Funds as these schemes can be highly volatile in the near term.

It is important to adopt a sensible approach when investing in Small Cap Mutual Funds and invest only if the investment mandate of the scheme is congruent with their own investment objectives.

Avoid going overboard with investments in Small Cap Mutual Funds in expectation of earning high returns quickly as past performance is not an indicator of future returns. Remember that investing in Small Cap Mutual Funds without a goal in mind or without understanding the various risks involved will be akin to gambling.

Investors should ideally maintain a well-diversified portfolio of various sub-categories of equity mutual funds that aligns with their investment needs. This will help them to earn optimal returns at a reasonable level of risk.

[Read: Rally in Mid Cap and Small Cap Funds: Should You Buy More or Sell Now?]

To conclude:

Small Cap Mutual Funds offer investors an opportunity to create substantial long-term wealth. Many small-cap companies today are engaged in niche, innovative and sunrise businesses, such as green energy, new-age technology, drones, AI, geospatial systems, genomics, semiconductors, clean mobility, food processing, biotechnology, logistics, and so on that have the potential to grow market share in the future.

However, it is important to approach Small Cap Mutual Funds prudently as they are inherently risky. One should avoid investment decisions based on market sentiments and instead focus on creating a portfolio that can help you navigate the ups and downs of the market. Prefer schemes that have performed consistently well over the years rather than schemes that may have registered one-off supernormal returns.

Watch this video to check out PersonalFN’s list of the best Small Cap Mutual Funds for 2024: