Mutual Funds: How much to allocate to smallcap funds in your portfolio?

If you are a long-term investor, you would have received this unsolicited advice many times that ‘you should invest in smallcaps for best returns’ in the long term. And to be fair, if you look at the returns of smallcap funds in the last few years, they have indeed delivered on the promises.

If we look at the last three years’ data of smallcap funds (with at least 3 years of vintage), then here is what they have achieved:

• In the last 1-year period, the best and worst smallcap funds have delivered a return of 75.0% and 41.4% respectively. In comparison, the largecap index of Nifty 50 has given 28.15%.
• In the last 2-year period, the best and worst smallcap funds have delivered a CAGR of 55.3% and 35.6% respectively. In comparison, the largecap index of Nifty 50 has given 24.01%.
• In the last 3-year period, the best and worst smallcap funds have delivered a CAGR of 34.9% and 21.4% respectively. In comparison, the largecap index of Nifty 50 has given 15.44%.

Note - The above data is based on the fund NAVs as of 25-June-2024.

It is clear that the last 2-3 years have been crazily good for smallcap investors and almost no one is complaining. And why would anyone?

But does it mean that you should invest everything in smallcaps?

The answer is a big no! New entrants in markets who have just seen the last few years won’t agree, but smallcaps can also have bad days. And when they have bad days, they are brutal, to say the least. If you don’t want me, I request you please check the market history of the 2008-09 bear market. You will see what a smallcap bloodbath looks like when it comes to that.

Coming back to the main discussion then.

While it is quite hunky dory with smallcaps till now, and you may still be tempted to invest heavily in them, what is the correct approach here? And how much should your smallcap exposure be?

Different people will give different answers. Some ultra-aggressive investors might be okay with a smallcap-dominated portfolio as well. But that isn’t everyone’s cup of tea. It is too risky an approach no matter how confident you are.

So, when trying to build a solid, long-term portfolio, we need to be prudent and then decide how much to allocate to different market cap segments.

First things first - Invest in smallcap funds if you really understand the risks properly. Also, when you invest, you should be willing to remain invested for the long term, i.e. at least 5-7 years or better more.

Here are a few thoughts on deciding your smallcap allocation:

• Everyone doesn’t need to invest in smallcaps, even if their investment horizon is several years. Only those who have a suitable risk appetite should be investing in this area.
• If you are an investor with a conservative risk profile, then whatever small equity exposure to equities you need, it is best serviced by largecaps alone. You can just invest in largecap funds and be done with it. Just ignore smallcap funds as you are neither suited for them nor do you need them.
• If you have some risk appetite and belong to the bucket of moderately aggressive investors, then at most, limit the smallcap exposure in your MF portfolio to a maximum of 25-30% of the overall equity exposure.
• And by 25-30% exposure to smallcaps, I don’t mean just smallcap funds. If you already have investments in other fund categories like flexicap funds, etc., then these funds also have some exposure to smallcaps. So, 25-30% should be the overall exposure to smallcap stocks across all the different funds from various categories that you have.
• So, suppose you have ₹10 lakh in largecap index fund, ₹10 lakh in a flexicap fund (which has 15% in smallcap stocks) and ₹5 lakh in smallcap fund, then your overall allocation to smallcap is ₹6.5 lakh (= ₹5 lakh from smallcap fund + ₹1.5 lakh from flexicap fund’s allocation to smallcap stocks).

What if you have been riding the smallcap wave of the last few years and sitting on neat profits?

The prudent approach here would be to rebalance back your smallcap allocation to lower levels or to a maximum of 25-30% of equity exposure. Anything more and for lack of a better phrase, you are playing with fire with your portfolio profits now!

I know, to many, what I have written above may not seem logical given how good the smallcap segment has done over the last few years. But it is for this reason one needs to be extra careful and not be overly optimistic about the segment when reviewing your long-term portfolios.

Disclaimer - The views expressed above should not be considered professional investment advice or advertisement or otherwise. No specific product/service recommendations have been made and the article itself is for general educational purposes only. The readers are requested to take into consideration all the risk factors including their financial condition, suitability to risk-return profile and the likes and take professional investment advice before investing.

Dev Ashish is a Sebi-registered investment adviser and the founder of Stable Investor