Why invest in Small Cap Funds at these levels?

There is great demand for small cap funds among retail investors over the past few months. In each of the months of this financial (FY 2023-24) on a year to date basis, small cap funds attracted the largest net inflows among all actively managed equity mutual fund categories. In April, May, June and July 2023, small cap funds got net inflows Rs 2,182, Rs 3,282, Rs 5,471 and Rs 4,171 crores respectively in these months. Small cap inflows constituted more than 50% of net inflows of actively managed equity fund categories (source: AMFI monthly data, April, May, June and July 2023).

What are small cap funds?

SEBI has classified stocks based on market capitalization ranks. Stocks below the top 250 stocks by market capitalization are classified as small cap stocks. As per SEBI’s mandate, small cap funds must invest at least 65% of their assets in small cap stocks.

Why invest in small cap funds?

• Since small cap stocks have lower revenues and profits compared to large and midcap stocks, their earnings growth potential is higher – percentage growth from a smaller base can be faster than growth from a larger base.


• Small cap stocks usually have high promoter ownership and relatively less ownership by institutional investors compared to large cap and midcap funds. As a result small cap stocks tend to be relatively less researched and provide more opportunities for price discovery compared to large and midcap stocks.


• Fund managers of small cap schemes see greater potential of generating higher returns compared to large and midcap funds by investing in small cap stocks that are currently being undervalued by the market.


• Stocks that are small cap today can become midcap or large cap in the future. When a stock moves into a higher market cap segment it can enjoy valuation rerating and create wealth for investors.


• The universe of small cap stocks (250+) is larger than the universe of large and midcap stocks combined. If we look at industry sectors, then the small cap universe includes sectors where large caps have no presence.


• Historical data shows that winners rotate across market cap segments. Large caps (Nifty 100 TRI) outperformed in 4 out the last 10 years, while small caps (Nifty Small Cap 250 TRI) outperformed in 6 out of the 10 years. Adding small caps to your portfolio will provide richer diversification and alpha creation opportunities over long investment tenures.

Source: Advisorkhoj Research as on 31^st July 2023. Disclaimer: Past performance may or may not be sustained in the future

Is this a good time to invest in small cap funds?

After underperforming in 2022, small caps have outperformed large caps and the broad market on a year to date basis (as on 31^st July 2023). Some investors may be wondering if this is the right time to invest in small caps since they have run up so high. Here some reasons why long term investors should consider small caps.

• Even though Nifty Small Cap 250 Index is at its all time, valuations (TTM PE multiple of 22.8 as on 31^st July 2023) are much more reasonable than what it was at the end of 2021 when the PE multiple of the index was around 31 (source: NSE, as 31^st July 2023).


• The Government has made huge budgetary allocations for infrastructure in the last 3 Union Budgets. Government’s infrastructure spending will benefit small cap companies in the construction, industrial goods and related sectors.


• The Indian economy is in a long term structural up cycle. Small caps will provide you exposure to sectors like chemicals, packaging, sugar and tea, ceramics and sanitary ware, hotels, logistics, construction, textiles, apparels, luxury goods, healthcare, application etc. These sectors are likely to have a great potential in the consumption driven India growth story.


• The chart below shows the 10 year rolling returns of Nifty Small Cap 250 TRI versus Nifty 50 TRI since the inception of the small cap index. You can see that Nifty Small Cap 250 TRI was able to outperform Nifty 50 TRI over 10 years most of the times, irrespective of the market levels when the investment was made.

Source: Advisorkhoj Rolling Returns. Period: 01/04/2005 to 31/07/2023. Disclaimer: Past performance may or may not be sustained in the future

Investors should consult with their financial advisors or mutual fund distributors if small cap funds are suitable for their long term investment needs.

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