Small-cap stocks have piqued investors’ interest again after a three-year slumber. Many small-cap stocks have more than doubled since March 2020 lows, owing to the muted interest rate environment and an aggressive governmental and regulatory push to bolster the economy. A visible uptick in retail spending has also helped smaller stocks regain momentum since June 2020.

The Nifty MidCap 100 and SmallCap 100 Index has delivered over 20 per cent and 17 per cent returns respectively, outpacing the 11 per cent gains on the NSE Nifty 50 Index (as of December 2020). Analysts are bullish on the small-cap sector for the foreseeable future.

However, the risk and volatility associated with small-cap stocks cannot be completely mitigated. For most retail investors, their best bet is via the mutual fund route. These professionally managed funds have dedicated teams of researchers and analysts who are not only adept at picking and monitoring the right stocks but also in a position to pivot quickly in response to changing market conditions.

As an investor, here are some factors to be mindful of.

Internal factors: These pertain to your own behavioural qualities and investment needs.

• Investment philosophy

Spend some time to understand the fund/ manager’s investment philosophy, stock selection process, and fund allocation. It is important that the portfolio’s objectives are in line with your own interests and risk appetite.

• Investment horizon

It usually takes three to five years for stocks that are diamonds in the rough to truly start delivering returns. However, a seven to ten year dedicated and disciplined investment period helps truly generate superior returns and recoup notional losses, if any.

• Risk allocation

Investors need to periodically assess the risk exposure these funds bring, not just to equity assets, but to the overall portfolio. Leveraging the expertise of a financial advisor can help you structure a portfolio that counters the risk and volatility of small-cap investments. Experts suggest a maximum exposure of 5 per cent to 8 per cent of the total portfolio towards such funds.

External factors: They refer to theassessing criteria for picking funds for your portfolio.

• Management

One should invest with an Asset Management Company and fund manager who has a proven track record of identifying promising stocks and a keen eye on risk management. Shortlist funds that have been around for at least six to ten years. One should ideally opt for funds that have managed to outperform the benchmark index during both, bull and bear phases.

• Performance

The monthly factsheet issued by fund houses gives a clear insight into the fund’s performance. To assess the growth potential of the fund, do check the price to equity ratio at your time of investment. It will shed light on how much the fund is overpaying for growth. Filter out the ones that have a price to equity ratio in excess of 30 multiples – 40 multiples, which are considered to be relatively overvalued.

• Fund size

Over 95 per cent of the businesses listed on the exchange are classified as small-cap companies. Even for the most experienced fund manager, identifying and building a portfolio of robust small-cap stocks is a mammoth challenge. Subsequently, managing the fund amidst risks such as poor liquidity and governance issues is another concern. Hence, as an investor, it is always recommended to seek a fund that does not dilute the quality of investment or is too illiquid to exit.

Conclusion

Investors with a long-term investment horizon and an appetite for risk can look at an exposure of 5-7 per cent to small-cap funds. They exhibit high volatility and are set to have amplified highs and lows in cycles. For the uninitiated, robo-advisory WealthTech platforms and wealth advisors can help cut the clutter and identify the right investment avenues to deploy your funds. A diversified portfolio of investment options also makes it a lot easier to invest and stay on track for long-term wealth creation.

The author is Co-Founder and CBO, at Scripbox