Mumbai: Retail investors have taken an instant liking to smallcap funds, adding a record 6.5 million lakh folios last year, leading to a 75% surge in assets under management (AUM) in the category.

The AUM under this category of funds has surged to ₹2.28 lakh crore at the end of last year.

However, after the sharp run-up in valuations, wealth managers believe this performance is unlikely to be repeated, and have asked investors to stagger their purchases in small cap stocks and come with a longer time frame.

“After the small cap index’s 59% gain in CY23, we believe the space as a whole has witnessed a very good valuation catch-up and now small caps are trading at a premium to the large caps,” said Krishna Sanghvi, Chief Investment Officer, Mahindra Manulife Mutual Fund.

Sanghvi believes that stock-specific possibilities remain in small caps due to the profit growth potential of these companies and investors should deploy money in a staggered manner over a three to five year period.

Over the last one year, large caps represented by the Nifty 50 rose 18.46%, while the Nifty Smallcap 250 rose 52.5%, leading to a surge in valuations of small caps. “From the Covid lows of March 2020 the Nifty Small Cap Index has outperformed the Nifty 50 by 62%. The Nifty Small Cap Index is trading at a forward PE of 20.7 compared to the Nifty 50’s 19.7,” says Rusmik Oza, Founder, 9 Rays EquiResearch Small Cap Index. Oza believes the correction in small caps can be sharper given the premium valuations and feels its time for investors to take some profits in small cap stocks,

Distributors point out that investors tend to chase past performance while making fresh allocations, without paying attention to valuations, which is leading to a surge in flows. While large cap stocks that as a category returned 18.46% over the last one year saw addition of 3 lakh folios, small caps which returned 52.5% saw addition of 65 lakh new folios. “Many investors chase past returns and are still putting money in small caps because they are on top of charts in 1 year return,” says Nikhil Gupta, Founder, Sage Capital.

While large cap funds need to allocate 80% of their portfolio to stocks ranked 1 to 100 by market cap and midcap funds need to allocate 65% to stocks ranked 101-250 by market cap, small cap funds cover a larger universe of companies. Small cap funds need to have a minimum of 65% in small cap stocks, which are ranked 251 and below by market capitalisation, giving it a larger pool of companies. Small cap funds also have higher allocation to segments like capital goods and manufacturing and lower allocation to financials. Many stocks in niche categories like wealth management, chemicals, etc are present in the small cap space only.

Given the flexibility that small caps offer to fund managers, Nikhil Gupta believes investors should have a 15-20% allocation to the category in their equity portfolios and given the current elevated valuations they should build this through staggered investments with a time frame of 3-5 years.

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