Rationale behind the rush for small cap funds

At the other end of the spectrum, large-cap funds witnessed an outflow of R3,360 crore during the same quarter.
Image used for representational purpose only. (Express Illustrations)
Image used for representational purpose only. (Express Illustrations)

After reviewing the industry and segmental figures for the last quarter against the backdrop of the anticipated market uptick, my team pointed out that for the third straight month in June 2023, the inflows into small cap funds were the highest, clocking record high inflows on a month-on-month basis of R 5,472 crore.  

If one dissected the numbers of the entire quarter from April to June, 2023 (Q1), as per the data provided by the Association of Mutual Funds in India (AMFI), it is the small cap funds that topped the inflow charts, with a net aggregate of R11,000 crore. At the other end of the spectrum, large-cap funds witnessed an outflow of R3,360 crore during the same quarter.

Lest it gets mistaken to be a one-off, it is worth stressing here that even in the prior quarter i.e. January to March, 2023 (Q4 of FY 2022-23), small cap funds clocked inflows of over R6,900 crore. This sharp surge of inflows has pushed the assets under management (AUM) of small cap mutual funds up by 28% to R1.7 lakh crore at the end of June 2023 as compared to R1.33 lakh crore at the end of March 2023.

Meanwhile, over the last half decade, the universe of small caps has literally doubled from R8,580 crore in 2017 to R16,400 crore in 2023. This increase in the market capitalisation of small cap companies also lowers (at least theoretically) the primary risks of illiquidity and higher volatility usually associated with small cap stocks.

Given that a lot of mutual fund investors still invest based on the category of funds that have the best return numbers at a given point in time, it should come as no surprise that the small cap funds category’s performance numbers have been substantially boosted this year in the ongoing market rally.

This category has recorded handsome returns with a compound annual growth rate (CAGR) approximating an average of 34% over the last one year, 42% over the last three years, and 19% over the last five years. 
By any yardstick, these are indisputably very good numbers. So why is this happening ought to be the logical question that follows.

Historically, it has been noticed that when there is a stream of steady inflows even after the market has run up, the valuation gap between small cap companies and large cap companies widens. In such a scenario, the excess liquidity almost inevitably gravitates towards small-cap companies as fund managers start seeking out value within the otherwise neglected category.

This in turn provides the alpha that has become far more difficult to generate in the large cap category and boosts performance numbers, which again, fuels further liquidity and inflows.  Clearly then, there is inherent higher risk in the allocations to this category but for those with the requisite risk appetite, the potential rewards are enticing enough.

In the next column, we shall delve more deeply into the category of Small Cap Funds, its definition and investment universe.

(Views expressed here are personal)

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