"Considering Small-Cap Funds? Key Factors to Keep in Mind"

Before investing in small-cap funds, it’s important to consider key factors such as higher risk, growth potential, market volatility, and the fund’s investment strategy. Small-cap funds can offer significant returns but may also experience more fluctuations compared to larger companies. Assess your risk tolerance, research the fund’s track record, and ensure it aligns with your long-term investment goals before committing.

Experts recommend focusing on small-cap funds with quality stocks and a proven track record, while using the SIP route to minimize volatility risks.

Over the past month, small-cap funds have experienced the greatest correction among diversified equity funds, highlighting the substantial risks they face during market fluctuations.

Generally, this category of funds is more susceptible to market shocks compared to stable large-cap, multi-cap, or flexi-cap funds.

Small-cap funds have fallen by an average of 7 percent in the last month, while mid-cap funds dropped by 6.5 percent and large-cap funds by 6 percent. Although still negative, multi-cap and flexi-cap funds performed better than small-cap funds during this period.

Data from the Association of Mutual Funds in India (AMFI) for October 2024 revealed that while the Indian equity market saw a 6 percent correction, small-cap funds suffered a decline in the quality of their assets. The BSE Sensex and NSE Nifty fell by 5.77 percent and 6.22 percent, respectively, last month.

Longer Redemption Periods
When markets decline sharply, more investors typically withdraw their investments. In such cases, an illiquid mutual fund may halt redemptions, which can cause panic in the market.

A fund’s liquidity is crucial as it indicates how quickly it can sell stocks to generate cash for redemptions if many investors want to pull out their money. Stress tests aim to assess how quickly fund managers can liquidate their portfolios in the event of a rush for redemptions during adverse market conditions.

The latest stress-test results for mutual funds in October 2024 revealed that the top 15 small-cap funds would require an average of 25 days to liquidate half of their portfolios, compared to 22 days the previous month. Nippon India Small Cap, the largest small-cap fund, would now need 31 days to offload 50 percent of its portfolio, up from 26 days last month. The fund's cash allocation also increased from 4.06 percent to 5.31 percent on a month-on-month basis.

The SBI Small Cap Fund now requires 56 days, 10 more than the previous month, to redeem half of its portfolio, according to the latest data. Quant Small Cap Fund now takes 55 days to liquidate half of its portfolio, with its cash allocation decreasing from 13.06 percent to 11.15 percent month-over-month. Among the top 15 small-cap funds, Franklin India Smaller Companies Fund saw a significant increase in cash holdings, rising to 5.6 percent from 2.4 percent.

Risk Mitigation Strategies for Small-Cap Funds
Fund managers use several strategies to mitigate risk and safeguard investors' interests during market corrections. For diversification, small-cap funds invest in a range of small-cap stocks across different sectors. These funds may also include liquid mid-cap and large-cap stocks, helping to spread risk and reduce the impact of any individual stock’s performance on the overall fund.

Additionally, small-cap funds typically hold a portion of their assets in liquid securities such as cash or short-term debt instruments. This strategy ensures flexibility to manage cash flows and meet redemption requests during market downturns. "Fund managers may employ various risk management tools, such as stop-loss orders, hedging strategies, and derivatives, to limit downside risk," said Viral Bhatt, founder of Money Mantra.

How to Select Small-Cap Funds
Investing in small-cap funds during market corrections can be a strategic move for long-term investors. Here are some key strategies for navigating this approach:

• Systematic Investment Plan (SIP): By investing a fixed amount regularly through SIPs, investors can buy more units when the market is low and fewer when it’s high, effectively reducing the average cost per unit over time.
• Bottom-Fishing Challenges: If you are able to identify the market’s low points, lump-sum investments can be effective. However, timing the market is difficult, so caution is advised.
• Gradual Investment: Another approach is to invest in smaller portions over time to reduce the impact of market volatility.

According to Bhatt, the best strategy right now is to focus on quality and long-term potential. "Select strong funds and choose those managed by experienced fund managers with a proven record of selecting quality small-cap stocks," he advised.

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Source: moneycontrol‍