Small-cap funds have traditionally been a popular choice for investors seeking growth, with the belief that investing in smaller companies can yield greater returns over time. A recent report by Share.Market, published by PhonePe, questions this assumption, suggesting that the advantages of small-cap funds may not be as pronounced as some investors have assumed. Although small caps showed better returns than large caps over the past two decades, the differences may warrant a closer inspection.

The study draws from 20 years of performance data, comparing the Nifty Small Cap 250 Total Return Index and the Nifty 100 Total Return Index. The findings indicated that the Nifty Small Cap 250 achieved annualised returns of 12.54 per cent, compared to the Nifty 100’s 11.72 per cent. While this suggests a lead for small caps, the actual difference in annualised returns stands at just 0.82 percentage points, prompting the question of whether the higher returns justify the increased risks.

Volatility and Risk Considerations in Small-Cap Investments

The report highlights that obtaining these higher returns is accompanied by considerable challenges. Investments in small-cap companies witnessed an annualised volatility of 28.81 per cent, notably higher than the 21.06 per cent associated with large-cap stocks. This greater volatility translates to more significant fluctuations in portfolio value, particularly during market downturns. As outlined in the report, this creates a risk-reward scenario where the modest increase in returns does not necessarily balance out the heightened uncertainty faced by investors.

The cyclical nature of small-cap performance emerges as a significant theme in the analysis. During bullish market phases, small-cap stocks often outperform their larger counterparts, as evidenced by exceptional returns between 2014 and 2017. However, the landscape changes drastically during periods of market corrections, such as from 2018 to 2020 when small-cap stocks underperformed. The report indicates that small-cap outperformance can vary widely, ranging from a high of 20.52 per cent during favourable conditions to a decline of 17.16 per cent during adverse ones, emphasising the importance of market timing in small-cap investment strategies.

Strategic Approach Required for Small-Cap Investments

Nilesh D Naik, Head of PhonePe Mutual Funds, shares insights regarding the approach investors should adopt when considering small-cap investments. He indicates that there is a prevailing misconception that simply holding small-cap securities indefinitely will yield optimal results. According to Naik, the correlation between past outperformance and future returns suggests that attention to relative valuations and market cycles may be just as critical as the duration of investment.

The report advises that following a recent correction in the market, the disparity between small-cap and large-cap performance has diminished. As valuations normalise from previous highs, the study identifies a potential opportunity for aggressive investors who can adopt a tactical mindset towards small-cap investing over the next 12 to 18 months. However, experts warn against the pitfalls of chasing returns indiscriminately, recommending a focus on funds known for their consistent performance and a disciplined investment style emphasising quality and value.

In conclusion, while the historical data suggests that small-cap funds have delivered slightly better returns than their large-cap counterparts, the journey tends to be more volatile. As the study highlighted, successful investing in this sector requires an understanding of associated risks, careful fund selection, and a recognition of the cyclicality inherent in small-cap investments. Thus, small-cap funds can be considered for long-term growth, but other factors such as timing and valuations will also significantly influence outcomes.

Long or Short, get news the way you like. No ads. No redirections. Download Newspin and Stay Alert, The CSR Journal Mobile app, for fast, crisp, clean updates!

App Store –  https://apps.apple.com/in/app/newspin/id6746449540 

Google Play Store – https://play.google.com/store/apps/details?id=com.inventifweb.newspin&pcampaignid=web_share