Investors' Hangout: Should you sell your small-cap funds?

So, the small-cap funds are clearly emerging as the favourites of retail investors. As per AMFI data, of the total folio addition in August 2023, 38 per cent was in small-cap funds, and it was the largest among all mutual fund categories. What do you have to say about that?

I have to say that naive investors, individual investors are greedy. And greedy for a reason, because if you're investing money - not in fixed deposit - but in the markets through a mutual fund, you would like to have superior return. That's the point. That's the reason why you're investing. Every investor is guided by what has done very well in the recent past. If you look at the last one year return table at Value Research Online, you will come across a bunch of small-caps only. And because they are the top of the pack, and what typically happens is that what does well starts getting money and because it starts getting money, it does even better. The cyclicality is driven by greed, which goes to a point where people realise that okay, it is not worth being greedy anymore. And then they lose money, then they learn it - some kind of rebalancing. That happens with something or the other. And that happens in stock prices as well. And so, looks like it is happening. Are we closer to the peak? Are we close to a point where it looks like it is very vulnerable? We might be very close.

Alright, is there any chance of them coming down very soon? And if they do, how bad can it get?

No, it depends.Even if they come down, assuming that they correct by or they fall down by 20 per cent and you're investing for 10 years or more, I don't think you have anything to worry about. If you started six months ago, you don't have much of an accumulation. The real problem is that somebody who started two years back with small-cap, all his money is in small-cap and he wished he had invested more, and when all his money will be down 20 per cent, that will be a problem because that could be quite unnerving for a new investor.

If somebody has been in the market for 10 years, I think people are used to it. A lot of people saw their small-cap slip by 30 to 35 per cent in 2020, recently during COVID, and it happened. In 2008, it was very severe. People almost gave up hope. It happens every five to seven years.

Let me just give you some history to this. In the year 2000, the first dot-com boom happened, and technology stocks were on fire. Everybody was investing in Infosys, and they were also investing in technology funds. We had four technology funds then, and the result that was visible as a result of madness around technology stocks was some of these technology funds were bigger than the diversified fund. It was a classic case of too many investors chasing a particular theme and pouring money. Then it happened as recently as 2006-07, when everybody was over invested in infrastructure stocks. You were investing in infrastructure stocks, and then you were in funds. And we came to a very funny situation where one fund company launched six infrastructure funds in two years' time. That was the flavour of the season. And everybody was launching some infrastructure fund every other day and that was over investment that led to the crisis. Also, a lot of investors were hurt. Look at the design of the SEBI classification. Top 100 companies are large-cap, next 150 companies are mid-cap and the rest of the universe - all the stocks, they are not big, they don't have depth. My sense is that we are getting close to a not so comfortable level for these stocks. I don't know how to curb this. This is a behavioural issue. And this keeps happening and it will keep happening, it will keep repeating. And this is the time where industry should actually formulate, at least Value Research followers, listeners and people who come here often, they should try and manage their risk, reduce their risk by their own actions, and it can be done methodically.

So can you give us a perspective on how bad it can really get?

Just go by the past, and not so in the distant past. We had 2008 when the global financial crisis happened. And that was the time when small-caps were not on the forefront. They were not ruling the market or driving the market. The result of being a small company is that when few investors sell, it is on a free fall. And that is what happens, and I don't think this time it will be different. So when small-caps were not on the forefront, and the 2008 crisis happened, they fell by nearly 60 per cent or in the technology crisis, it went down by something like 75 per cent. Think of your Rs 100 getting reduced to Rs 25. The result of that is not that people will recover, how long it will take and this and that. The result of that is even worse - the worse is that in the recent past, a lot of new investors have come in who are beginning to invest. And once they get experience of this kind, in one or two years time that they saw it soar and then collapse, they will say that this is all nonsense, and they will not come back again. And that is the scary bit.

Then there is another problem this time around. Earlier they could have blamed it on the advisor, or they could have blamed it on the fund company. No, this time people are choosing themselves. They are downloading an app, they are able to quickly participate, and nobody is holding their hands to make them understand how they should get started, how they should get initiated, because this is just one part of the story. The other part of the story will actually unfold, and that will be nasty, that can be nasty, that could be distasteful, and that could be scary. And investors can manage these issues. With little thought, if they step back and try and understand what's going on, and act accordingly, or build some shock absorbers.

Value Research will empower you with tools, but to be able to use Value Research, you need to understand two-three things very well - are you truly diversified or how much of your money is in small-cap. I don't think most investors would be able to figure out because they will have some shares, they will have some funds, they will have some funds of different kinds. Even if you have four funds, for example, you have two small-cap, because that has been the flavour of the season, and you have one multi-cap and then you have a tax-saving fund. And then you have five or 10 stocks which you bought, because you opened a brokerage account and that is how you invest. As a result of this, you don't know how much money you have in small-caps. When you set up your portfolio on Value Research Online, it will be able to tell you precisely that much - that this much money is in small-cap, this much is in mid-cap by virtue of investing in different investments because people will not have this context. And when they fall, everything falls, the small-cap component which is spread in all your investments, they will all be trapped. So you need to really prepare with that. And a good diversification is 70 per cent large-cap. If you're very venturesome - 50 per cent large cap, so you're aggressive, but 50 per cent large-cap is a good anchorage. Then making sure that 20-30 per cent is in mid-cap and remaining in small-cap. This is very aggressive. And if you're 70 per cent into small-cap, then you're actually poised for a nasty surprise which you may not be prepared for.

So according to you, who should be selling their small-caps at this point of time?

If you're 70 per cent in small-cap, it is a good time to get out gradually because people have regret, and that makes them make even bigger mistakes. Because assuming you take all your money out from small-cap because it has gone up very well, and it goes up even further. That is an imminent possibility. So what I suggest you should do is think of what is the target allocation to small-cap, if not 20 per cent, maybe you have aggressive one - 40 per cent into small-cap. And it has gone up to 70 per cent or maybe you have two small-cap funds and it is 100 per cent, reduce it methodically to 40 per cent. Move that money to mid-cap and large-cap in a methodical way and do it on a month-on-month basis. You are not out of the market. Also, this is the time when you should make sure that your short-term money is not invested in equity. Because typically what happens in our market like this, the small-cap is going up, it is not that the large-cap is actually lagging behind. It's going up but slowly, slower than small-cap. We are beginning to get questions on Value Research Online that should I borrow money and invest in stocks? This is a clear sign that people are getting greedy. And this is an alarming sign.

That's about selling it. Who should not sell their small-caps?

If it is up to 20-30 per cent of your total portfolio. Set up your portfolio on Value Research Online, that is the only place where you will get your precise exposure to small-caps. Nowhere else will aggregate all your investments spread across mutual fund, stocks, NPS for you and for your family together. Small-cap is not a bad thing, it is just that you should have the time-frame. If you're investing for any 10 year, small-cap will beat all other kinds of funds hands down, but if you are coming with a very short-term expectation, you will be very surprised in a very negative way.

Alright, so clearly small-caps are the favourites but you should be diversified well and have a ceiling in mind for the small-caps because if you go overboard, that's going to be difficult for you.

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