What Is the Ideal Exposure of Small-Cap Funds in Your Portfolio?

As a long-term investor, you may have frequently heard the unsolicited advice that “Investing in small-caps offers the best returns over time.”

But have you ever questioned the merit of this recommendation?

Small-cap funds are mutual funds that primarily invest in stocks of companies with a smaller market capitalization. These companies typically have the potential for significant growth but may also involve higher risk compared to large-cap funds.

If you look at the returns of small-cap funds over the past few years, they have indeed delivered impressive results.

Have they really fulfilled the expectations set by their advocates?

Let’s delve into whether investing in small-cap funds is as beneficial as claimed.

Examining the data for small-cap funds over the past 3 years (with a minimum of 3 years of performance), we can see their remarkable achievements:

In the last 1-year period, the best-performing small-cap fund returned 62.72%, while the worst delivered 27.52%. How does this compare to the Nifty 50 large-cap index, which posted a return of 29.61%?

Looking at the 2-year period, the top small-cap fund achieved a CAGR of 44.18%, whereas the lowest returned 18.52%. In contrast, the Nifty 50 large-cap index yielded 18.05%.

Over the 3-year span, the best and worst small-cap funds generated a CAGR of 28.79% and 13.75%, respectively. How does this stack up against the Nifty 50 large-cap index, which managed only 11.07%?

(Note: The data above reflects fund NAVs as of Oct 25, 2024.)

It’s evident that the last 2-3 years have been exceptionally favorable for small-cap investors, and there’s hardly any dissent. After all, why would anyone have complaints?

Is Putting All Your Money into Small-Caps the Right Strategy?

The answer is a firm no! New investors who have only experienced the past few years might disagree, but small-caps can indeed face significant downturns. When these downturns occur, they can be incredibly harsh.

If you’re skeptical, why not take a moment to review the market history from the 2008-09 bear market? It clearly illustrates what a small-cap bloodbath looks like.

Now, let’s return to our main discussion:

Small-cap funds can offer higher returns over the long term compared to large-cap funds, especially during bull markets. Their growth potential can be appealing for investors seeking significant capital appreciation.

While the performance of small-caps has been quite impressive so far, and the temptation to invest heavily in them is strong, what’s the right approach?

How much exposure to small-caps should you really consider in your portfolio?

Different people will offer various perspectives.

Some ultra-aggressive investors may be comfortable with a portfolio heavily weighted in small-caps, but that approach isn’t for everyone. Isn’t it too risky, regardless of how confident you feel?

When aiming to build a solid, long-term portfolio, it’s crucial to be prudent and carefully determine how much to allocate to different market cap segments.

First and foremost, consider investing in small-cap funds only if you fully understand the risks involved. Are you prepared to stay invested for the long term—ideally for at least 5-7 years, or even longer?

Key Considerations for Determining Your Small-Cap Allocation!

• Not everyone needs to invest in small-caps, even with an investment horizon spanning several years. Only those with an appropriate risk appetite should venture into this area.
• If you are a conservative investor, any small equity exposure you require can be adequately met through large-cap investments. Why complicate matters? Simply invest in large-cap funds and move on, leaving small-cap funds aside as they aren’t suited to your needs.
• For those with a moderate risk appetite, It’s advisable to limit your small-cap exposure to 25-30% of your overall equity investments, depending on your risk appetite. This allocation helps balance potential growth with risk management.
• But when I say 25-30%, I’m not referring solely to small-cap funds. If you already hold other fund categories, like flexi-cap funds, be aware that these may also contain small-cap stocks. Thus, your total exposure to small-cap stocks should be considered across all different fund categories in your portfolio.
• For instance, if you have ₹10 lakh in a large-cap fund, ₹10 lakh in a flexi-cap fund (which includes 15% small-cap stocks), and ₹5 lakh in a small-cap fund, your overall allocation to small-caps would be ₹6.5 lakh (comprising ₹5 lakh from the small-cap fund plus ₹1.5 lakh from the flexi-cap fund’s small-cap exposure).

Now, what if you’ve been riding the small-cap wave over the last few years and are sitting on substantial profits?

A prudent strategy would be to rebalance your small-cap allocation to lower levels, ideally capping it at 25-30% of your overall equity exposure.

Anything beyond that, to put it bluntly, means you might be playing with fire when it comes to your portfolio profits!

I understand that what I’m suggesting might not seem logical to many, especially given the impressive performance of the small-cap segment over the past few years. But isn’t that precisely why it’s crucial to exercise caution?

Shouldn’t we avoid being overly optimistic about this segment when evaluating our long-term portfolios?

Final Takeaway

In the dynamic world of investing, small-cap funds can indeed offer impressive returns, but they come with significant risks.

While recent performance may tempt you to increase your allocation to small-caps, it’s essential to remain grounded in your investment strategy. Understand your risk appetite, and consider diversifying your portfolio to include a mix of asset classes.

By keeping your small-cap exposure capped at 25-30% of your overall equity investments, you can benefit from potential growth while safeguarding your portfolio against severe downturns.