Are Small-Cap Funds Overvalued

Are Small-Cap Funds Overvalued?

Investing at the right amount and value is crucial to reap the most returns from your investments. This is especially the case for stock and mutual fund investments. When you talk about mutual funds, you hear of large caps, mid-caps, and small caps. These are different categories of mutual funds depending on the market capitalization of the companies in which the funds are invested.

One of the most popular among these three is the small-cap fund. Small-cap funds have recently gained much popularity due to the returns they provide. Parallely, it also raised a significant question: are small-cap funds overvalued?

Let’s break down the small-cap mutual funds and determine whether the concerns are true, and if yes, then to what extent. Stay tuned with Koshex!

What are Small Cap Mutual Funds?

To understand small-cap funds, you first need to understand small-cap companies. Small-cap companies refer to those companies whose market capitalization is less than Rs. 5000 crore. Mutual funds that primarily invest or invest the majority of their funds in these companies are referred to as small-cap funds.

Why do People Invest in Small Cap Funds?

Many people invest in small-cap funds because of the following reasons:

  • Attractive Returns: As the saying goes – The higher the risk, the higher the return. Small-cap funds have the potential to earn attractive returns that beat their mid and large-cap counterparts.
  • Faster Achievement of Goals: Everyone has long-term goals. Small-cap funds are an ideal choice for achieving these goals. As small-cap funds earn higher returns, they are ideally suitable to achieve goals at a faster pace as compared to other investment avenues.
  • Diversification: If you have been playing safe and want to diversify to earn more returns, then a small cap fund poses an attractive opportunity to invest. They can compensate for the returns of relatively safer avenues, thereby raising your overall portfolio returns.
  • Compounding: While you may not notice much difference in the shorter run, even a 1% difference in returns can create a huge difference in the long run due to compounding. Staying committed and consistently investing in small-cap funds over the long run can unlock the magic of compounding.  

What Happened In The Past Few Months?

To answer whether small-cap funds are overvalued, we need to understand the small-cap trend and track the returns and money pooled by small-cap funds during the past period.

In recent times, small-cap funds caught the attention of investors and suddenly became quite popular. As the funds continued to provide good returns, they saw huge amounts of money being poured in by Indian investors. In such a case, comparison with other fund categories becomes important here.

Investments in large-cap funds decreased in the last financial year. From 8.2% of total equity net flows in FY22, the net flows dropped to 5.7% in FY23 and witnessed a de-growth of 12.1% in FY24 (April to August). So where are the investments going?

It’s simple! Investors are getting attracted to mid and small-cap funds to earn potentially higher returns. While the money invested in mid-cap funds increased from 9.9% to 19.2%, the money pooled by small-cap funds increased from 6.2% to 41.9% in the financial year 2023-24.

Returns Provided by Small Cap Funds

The overflowing investments in small-cap funds are good enough to conclude that the returns provided by these funds are skyrocketing. As per research, in the past year, small-cap funds delivered 36% returns on investment, gaining investor’s attention.

Investors were carried away by the small-cap performance and started pouring in more and more money to take advantage. Thus, the prices of small-cap funds touched the roof. The Nifty 250 Small-cap index hit an all-time high. The 12-month price-to-earnings ratio soared over 24.

Consequences Of Sudden Inflows Of Investments

Apart from market capitalization, the companies classified into different categories also carry some differentiating features. Small-cap companies carry lower liquidity as compared to their other counterparts. When overflown with too many investments, their prices can shoot up, which can make them virtually unattractive from a valuation perspective. In case there is a change in market conditions, investors can take a hit. This is especially true when redemption pressures increase.

Fund managers had to make some crucial decisions when the investments didn’t seem to stop. Nippon India and Tata Mutual Fund halted lump-sum investments in small-cap funds. As per BQ Prime’s publication on 15th July 2023, the fund manager at Tata Small Cap Mutual Fund, Mr. Chandraprakash Padiyar, stated that it became difficult to deploy additional funds to these companies without surging their stock prices. Thus, the cash component of the Tata fund increased to 15% as compared to its usual 10%.

Padiyar further emphasized that whenever the fund invests in any stocks, it wants to buy more of them gradually. However, when the fund sees a massive inflow of money, as high as 5 times the daily inflow, then the cash level of the fund increases. As this cash does not contribute much to the funds’ performance, the funds’ performance gets impacted. Further, inflated valuations can decrease future returns when things start settling down.
Also ready :Equity Mutual Funds

Are Small Cap Funds Overvalued?

Having understood the actual scenario in the past few months and the growth trajectory of small-cap funds, we can now analyze whether the small-cap funds are actually overvalued.

There are 2 indicators that can help us determine whether small-cap funds are actually overvalued or not. Whenever stocks become too pricey, fund managers find it difficult to further invest more funds. They have the following options left:

  • They can increase the proportion of cash and cash equivalents in the funds. This cash portion can be used to grab any future attractive opportunities. However, until such an opportunity presents itself, the cash portion does not earn much return for the investors.
  • They can increase the number of equities in the funds by investing in other categories of companies, like mid and small-cap companies. As the size of these companies is huge, they can accept greater amounts of investment as compared to small-cap companies.

    Also read: 10 Best Mid-Cap Mutual Funds to Invest in 2024

If the above indicators start happening, then we can say that the small-cap funds are overvalued.

Summing Up

Small-cap funds may be overvalued presently, but it is just a temporary phase. In the long run, rupee cost averaging kicks in to average out the cost of your investment. However, it is crucial to select the right platform and invest in the right fund to not only have a seamless investing experience but also stay updated on the latest market trends.

Koshex is one of the pioneering platforms that allows you to choose among 5,000 different mutual funds to invest in. Small-cap funds, mid-cap funds, large-cap funds, debt funds, etc. – they have funds that can meet each investor’s needs and preferences. You can also diversify your portfolio by investing in other asset classes like digital gold, smart deposits, or even fixed deposits. Sign up with Koshex now!

Frequently Asked Questions

Q: Should we sell our units if small-cap funds are overvalued?

A: That depends on your investment goals and strategy. You should remain invested if you are carrying a long-term horizon.

Q: How to invest in small-cap mutual funds?

A: You can invest in small-cap mutual funds through investment platforms like Koshex. With 5000+ options, you can select any mutual fund across different categories based on your investment goals and preferences.

Q: If small-cap mutual funds are overvalued, will they continue to provide good returns?

A: Being overvalued is a temporary phase, and over a period of time, the small-cap funds too will gain their actual value. Historically, small-cap funds have outperformed mid and large-cap funds in terms of returns. So, it is important to do your own research and make informed decisions instead of panicking and making irrational decisions.