Is it time to exit small cap mutual funds?

Published: March 5, 2024 at 6:00 am

Many investors are worried about the “over-heated” small cap segment and wonder if they should exit — a discussion. At the time of writing, the last 1Y trailing return of small cap segments has ranged from 33% to 75%.

Regular readers may know that freefincal has always opposed investing in small cap mutual funds. Due to their highly volatile nature, returns can quickly swing from spectacular to disastrous and are most impacted by sideways market movements.

Investing in a flexicap fund with a “small” exposure to these funds is a relatively better idea. These are some of our earlier work on small cap funds:

So, if you are already invested in small cap funds and are wondering what to do, here are our suggestions:

Ask yourself these questions.

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  • What is my current asset allocation, and what is my target asset allocation? If you don’t know your target asset allocation, it is time to work on a financial plan.
  • What is my current small cap asset allocation within equity, and what is my target allocation? Again, if you don’t know this, you need to sit down a little (some of the above articles might help if you want data or proof).

We recommend no more than 60% equity allocation for goals over ten years away. Within this, 60% is zero per cent to small cap funds. If you “must” invest in these, do not exceed 20%. For every Rs. 100 you invest, not more than Rs. 60 in equity and not more than Rs. 12 in small cap funds (20% with equity and 12% overall). From time to time, if this small cap exposure exceeds the 20% mark by 5-10%, it is time for a reset.

If you have been investing without a plan and most of your money is in small cap mutual funds, sit down and create a plan, sell some small cap units and invest them in either fixed income or equity large cap, depending on your targets. Please remember that having more small caps will not get you more returns or make you richer quicker. See: Is there any proof small cap mutual funds would outperform in the long term?

If your equity allocation is at least 5% higher than the target overall allocation, sell some small cap and invest in fixed income to reset.

If you are debt-heavy, but your small cap allocation is quite high in your equity portfolio, now would be a good time to reduce it.

Can I make a tactical switch between large cap and small cap funds? I don’t see any harm in this if you focus on the overall asset allocation and a goal-based target corpus. See: Profit Booking from Small Cap Mutual Funds: Does it work?

You can either have a tactical strategy as above or like this – Do not use SIPs for Small Cap Mutual Funds; try this instead! Or you can use valuation metrics or events like funds* stopping or limiting subscriptions in small cap funds (to shift from small cap to large cap or fixed income).

* These are not to be treated as definitive events. Nippon Small Cap stopped lump sums in July 2023, while Kotak Small Cap placed restrictions only a few days ago (effective March 4th 2024).

So keep in mind that a correction may not (will not) happen as soon as you exit, and funds may gain further. So, tactical decisions may not work for you if you are a fan of regret.

We reiterate that investors are better off not investing in small cap funds. See: Why a SIP in Small Cap Mutual Funds wastes money and time. Most of whatever they gain quickly is also lost quickly, resulting in frustration. A more sedate approach is better suited to participate in the marathon of wealth building.

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