Fears of an asset bubble in small-cap stocks: Stagger investments in small-cap funds – Money News

With several fund houses restricting investments in their small-cap funds and the markets regulator also now expressing concerns over frothy valuations, individuals must exercise caution. They should opt for systematic investment plans (SIPs) and avoid lumpsum investments in this segment, say experts.

Before investing in small-cap funds, investors must note the fund size. If it is too large, then generating alpha would be difficult. Individuals should stay invested for over five years to earn higher returns. And the return expectations need to be around long-term averages and not what the market has delivered over the past one year.

Restrictions on investments

Taking a cue from the markets regulator, Association of Mutual Funds in India has directed fund houses to find ways to protect the interest of small-cap investors in a frothy market. As the small-cap segment is in an overbought zone, fund managers are finding fewer reasonable opportunities to invest in. The assets under management of small-cap schemes rose 89% to Rs 2.48 trillion in January from Rs 1.31 trillion in the same period last year.

In July 2023, Nippon India Mutual Fund and Tata Mutual Fund stopped accepting lumpsum investments in their small-cap funds. Last week, Kotak Mahindra Mutual Fund  restricted lumpsum investments. Given the inherent volatility and lower liquidity of small-cap stocks, the imposition of restrictions underscores the importance for both existing and new investors to proceed with caution.

Nirav Karkera, head, Research, Fisdom, says investors need to assess their risk tolerance, investment horizon and financial objectives before venturing into small-cap investments beyond a certain threshold. “Prudent decision-making and meticulous risk assessment are essential in navigating the dynamic landscape of the small-cap market.”

Prefer SIP mode

SIPs can help mitigate the impact of market volatility. Chandraprakash Padiyar, senior fund manager, Tata Mutual Fund, says investors should invest in small-cap funds through the SIP/STP (systematic transfer plan) mode and take a long-term view. “Return expectations need to be around long-term averages and not what the market has delivered in the last 12-24 months,” he says.

What to keep in mind

Before investing in small-cap funds, check that the fund size is not  too large. In that case, allocating money and generating alpha would be difficult for the fund manager. Small-cap funds are suitable for those with an aggressive or moderately high-risk appetite and a longer investment horizon, preferably seven years or more.

Mukesh Kochar, national head of Wealth, AUM Capital, says the risk ratios are very important while selecting the fund as this category is all about managing risk well. “The fund manager’s track record along with the consistency of outperformance of the benchmark is important. An investor should choose two to three funds at least for investment depending on the size of the investment,” he says.

Avoid FOMO

The ‘fear of missing out’ (FOMO) is prompting investors to invest in small-caps as this segment has outperformed other categories. “Fear and greed are dominant but we can control this by accurately checking the risk profile,” says Abhishek Banerjee, founder & CEO, Lotusdew Wealth & Investment Advisors.

If investors find their allocation is skewed heavily towards small-caps, they may need to rebalance their portfolio. This could involve profit booking. “A balanced approach that considers both small-cap and large-cap funds may be appropriate, based on individual circumstances and investment goals,” says Karkera.

In the past 12 to 25 months, the high returns from small-cap funds were on a low base after a very sharp correction witnessed in 2018-2020. “We believe returns will normalise towards long-term averages and it is advisable to not assume high returns,” cautions Padiyar.