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Small cap equity now? Think about risk, not return.

Does this seem like an opportunity to start investing in small caps?

The NSE Small Cap 250 index has corrected slightly over 20% between August 2018 and August 2019. If you are an aware investor tracking this change, you will realise that the correction in the small cap space is a lot more than the large cap index, NSE Nifty 50 which is down roughly 8% from 12 months ago. Does this seem like an opportunity to start investing in small caps? 

Should we look at returns?

The intuitive way to answer this question is to analyse how much returns have suffered in the past, see where small cap stock valuations have fallen to and then decide whether to invest or not. 

Let’s see what returns tell us. The small cap index is down 20%. The table below shows you the correction in small cap funds over the last 3 and 12 months. 

Performance of small cap funds in the last year
Returns as on 29th August 2019, regular plans
There has been a significant fall. As stock prices have corrected, so have valuations making the category more attractive for investors. The NSE Small cap index PE multiple is down from levels of around 65 times to 40 times as of August end.

Hence, is this a good time to buy?

Before we go ahead with this, lets take a quick look at the long-term return across categories. 


Seen today the 10-year return for the small cap category isn’t great when compared with other categories (See table). But none of the other categories share the high risk of drawdown (correction) that small cap funds have. Why take on the risk of investing in small caps if volatility means that return premium can fall significantly even in the long term? 

Moreover, the small cap returns shown in the first table shows the kind of variance in returns across schemes, which also tells us that the risk in small caps can be relatively higher compared to other categories.

What this means is that it is not about return. It is about risk. In a bid to get a potentially higher return in the long run are you willing to take the risk of extreme volatility (and potential loss of capital )?

The answer lies in your ability to understand risk

What this means is that it is not about return. It is about risk. In a bid to get a potentially higher return in the long run are you willing to take the risk of extreme volatility (and potential loss of capital )?

Let me give you the example of just one small cap fund, SBI Small Cap. This fund returned around 77% in the one year between January 2017 and January 2018. It was the best performing fund in the category and many distributors and investors wanted a piece of the pie.

The fund began getting too much demand and closed for fresh inflows in order to manage the existing portfolio better. A year later, in January 2019, the fund’s one-year return was 20%. Those who bought it looking at the past performance, are sure to have been disappointed. 

Are you comfortable with this level of volatility? In small cap funds extreme returns are a feature you will have to deal with across your investment horizon. One hopes that when you are closer to the goal, it is indeed a good phase rather than a weak phase for small caps. 
If you are unsure about your comfort with extreme volatility, stick to large cap and multi-cap funds for your long-term goals.

These are less volatile and hence, risk of not achieving your expected level of return is lower. If you must go the small cap way, allocate a small 5%-10% of your portfolio rather than committing large amounts. In this way, you can rejoice at the upside and not feel too cheated if the returns disappoint.
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