Small-cap rally: can you time the perfect exit?

In the dynamic world of investments, one often hears the phrase, ‘timing is everything’. While timing can certainly be a powerful ally in the realm of small-cap funds, it’s not the only strategy that can lead to success. In fact, for many investors it can be elusive and, more often than not, just out of reach.

Small-cap funds are lately drawing investors like moths to a flame with their impressive compounded annual growth rates (CAGR). These funds have exhibited an average CAGR of 36% over the last three years, outstripping the 3-year CAGR of the Nifty 50 TRI.

Data from the Association of Mutual Funds in India for July show that small-cap funds saw an influx of ₹ 4,171 crore into their assets under management (AUM). However, here’s where it gets tricky—the increased inflow makes it challenging for the fund managers to effectively manage it. As a result, some schemes have temporarily stopped accepting further inflows.

The unpredictable nature of market timing

Even as heavyweight fund houses like Nippon and Tata hit the brakes on fresh inflows, the overall AUM for the small-cap category continues to balloon. But before you dive headfirst, remember this: timing the market perfectly is akin to catching lightning in a bottle. Here’s why:

Investing in upturns: Small-cap stocks thrive during economic upswings and growth phases. However, predicting the precise start and end of these market cycles is a herculean task.

Investing in downturns: Some investors take the contrarian route, entering small-cap funds during market downturns when prices are low. While this can be a profitable strategy, it demands nerves of steel to endure extended periods of uncertainty. Moreover, these are the time where everything looks to fall apart.

Snooze or recovery periods: Small-cap funds are prone to extended periods of dormancy or recovery following sharp corrections. Many funds have experienced recovery periods well exceeding three years. This underscores the need for a balanced approach that considers growth potential and risk tolerance.

Fund size matters: In the case of small-cap funds, the fund size is a fundamental yardstick. Given the shallowness of the small-cap segment, the impact cost is very high for a fund manager with a very large AUM if there os a need to quickly deploy into or exit from a specific stock.

When should one invest in small caps?

Remember that timing is just one piece of the puzzle. While it can be alluring, a staggered investing, long-term perspective and a diversified portfolio can help mitigate the risk of entering at a bad time. Small-cap funds can inject vigour into your portfolio, but they should be approached with caution and a comprehensive understanding of the associated risks. As a final note of caution, it’s essential for retail investors not to get blinded by the current small-cap rally if they don’t intend to stay invested for the long-term.

Arihant Bardia is CIO and founder, Valtrust