the market rally tempting you? Before investing in smallcap funds, thoroughly understand the dangers

 the market rally tempting you? Before investing in smallcap funds, thoroughly understand the dangers

It is important to choose investments carefully and to have the patience to hold onto them for at least 5-7 years.

Being a small-cap investor is challenging. Not just at the level of a single (smallcap stock), but also at the category level, the market is very volatile. To be honest though, the most recent returns have been amazing.

The accompanying table compares the return profiles of largecap Nifty-50 based index funds and smallcap funds (AUM > Rs 5,000 crore as well as at least 2 years old).

Smallcaps have performed well over the past five to six months, but they have also helped to support the 1- and 3-year return profile of these funds. And it's absolutely stunning. Good smallcap funds have had a 3-year CAGR of 30–40% compared to the benchmark Nifty50's 16.9%. If you examine 1-year results, the narrative is similar.

While it may be alluring to think that the smallcap party will never end, let's step back a little. If you look a bit further back in time and keep in mind that trees don't grow to the sky and that the pendulum always swings, you will notice that the returns on small-cap stocks swing dramatically. These are undoubtedly life-changing in good years, but they can also be incredibly frustrating and destructive in poor years.

Note: According to SEBI categorization definitions, smallcap stocks (which are a component of smallcap funds) are the stocks of companies ranked 251 and higher by marketcap.

How much money should you set aside for small-cap stocks?

On how to construct a portfolio and how much capital should be allocated to various market groups, different people have varying views.

Some folks I know would like to have no exposure at all to largecap stocks. They only manage portfolios based on mid-smallcap stocks. Everyone is free to do as they choose, but in my opinion, the majority of people would not benefit from such a tactic. It is advised to steer clear of this extremely dangerous tactic.

Furthermore, I am aware that a lot of investors will be persuaded by the recent outperformance to make sizable investments in smallcap funds. But that is not the best course of action.

Only those with the patience to hold onto their investments for at least 5-7 years and a thorough understanding of the hazards should invest in smallcap funds. And be prepared to wait even longer than 7+ years if you are coming to invest here after a very successful moment.

What then ought should you do?

Here are some guidelines:

Ignore smallcap funds if you are a cautious investor with little exposure to equities. You are not welcome here.

For investors who are somewhat aggressive to balanced, I advise keeping their exposure to smallcap stocks to no more than 20 to 25 percent of their total equity exposure. Nothing more unless you are extremely greedy and/or prepared to take assured higher risks in exchange for maybe unguaranteed better rewards.

If you have been investing in smallcap funds for a while and your allocation has grown (as a result of a run-up in the smallcap market), it is good to assess and reduce your smallcap allocation to lower levels. The maximum equity exposure to smallcaps should be up to 20–25 percent, as was stated in the preceding point.

If you planned to invest a fresh lump sum of money in smallcaps because you (think you will) want to stay at the party for a while, use extreme caution. The music can stop unexpectedly in the smallcap area, and leaving quickly is not always simple.

If you have SIPs set up in smallcap funds and you are investing for a considerable amount of time (10+ years), you can leave them in place. But don't forget to rebalance the smallcap portion of the current portfolio.

Although it might seem strange, the majority of regular investors don't even require smallcap funds. This belongs in the category of goods that are best avoided.

Additionally, keep in mind a few considerations if you must invest in smallcap funds.

The alpha potential varies across different market groups. And while using a passive strategy for largecaps is acceptable, using an active strategy for smallcap funds is preferable right now. The amount of the fund is very important here. Smaller AUM funds are typically expected to perform better, however this is not always the case (as has also been observed recently). Additionally, various fund managers have unique investment approaches that may or may not be successful at various points in time. So if you decide to invest in smallcap funds, choose them wisely.