Evaluating the risk management techniques for small-cap fund investors

Small-cap funds invest in shares of small companies that are ranked beyond 250 based on market capitalisation. While small-cap funds carry a high potential for growth over the long term, they also involve higher volatility and risks compared to large-cap and mid-cap funds. As an investor in small-cap funds, it is crucial to understand the risks involved and use proper risk management techniques to optimise your small-cap fund investment.

Table of contents:

1. Risks associated with small-cap funds
2. Small cap funds - How to manage risk
3. Suitable Small-Cap Allocation for Investors

Risks associated with small-cap funds

Small-cap companies are younger and smaller in size and operations compared to large-cap companies. This makes their business models and operations more vulnerable to setbacks and fluctuations in the economy. Some key risks to consider as a small-cap fund investor are as follows:

• Volatility risk: Share prices of small companies seesaw more sharply with market movements compared to large-cap stocks or mid-cap stocks. Small-cap funds tend to have higher volatility.
• Liquidity risk: Smaller companies have lower trading volumes for their shares. This might make it difficult to sell your holdings quickly in times of downturns.
• Business model risk: Smaller firms have shorter operating histories. Their business models are often unproven over different economic cycles.
• Financial risk: Small companies have lower access to capital. Any adverse business/financial setback can impact their operations and survival, thus impacting the performance of small cap funds that invest in them.
• Concentration risk: Small-cap funds may take high exposure to specific sectors/stocks. This can lead to higher concentration risk in the portfolio.
• Lack of coverage: Smaller companies tend to attract lower analyst/media coverage and availability of information is lower.

Small cap funds - How to manage risk

Here are some practical tips for investors to manage risks in small-cap fund investments:

• Moderate allocation: Limit your allocation to small-cap funds to 10-20% of your overall portfolio. This can ensure that high-risk exposure is capped at prudent levels. Avoid taking overly aggressive bets on small-cap funds.
• Diversify across funds/stocks: Invest in 2-3 small-cap funds rather than just one. This ensures your portfolio is diversified across fund managers and investment approaches. Also, choose actively managed diversified small-cap funds over sectoral/concentrated funds.
• Long investment horizon: Small-cap investments require a patient, long-term outlook of at least 5-7 years. Their volatility tends to even out over longer time frames. Avoid knee-jerk reactions to short-term fluctuations.
• Systematic Investment Plans (SIPs): Prefer systematic SIP investments over lumpsum investments in small-cap funds. This averages out your purchase costs and reduces timing risks. Keep SIPs running even during market downturns.
• Avoid redemptions in down markets: Don't rush to redeem your small-cap investments during periods of sharp correction. Give time for recovery as downturns are temporary but loss realisation is permanent. .
• Monitor performance: Keep a close watch on your small-cap funds' performance across market cycles and peer comparisons. Review holdings periodically. Replace underperforming funds after giving sufficient time to recover.
• Risk profiling: Those with lower risk appetite and near-term goals should limit exposure to small-cap funds. These are more suited for investors with a very high risk tolerance and long investment horizons. Small cap fund techniques for investors like maintaining balanced allocation across large-cap, mid-cap and small-cap assets is crucial for effective portfolio management.
  Important tips for small cap fund investors are to avoid overexposure and maintain long investment horizons to ride out volatility. Prudent risk management techniques for small cap fund investors involve diversification across stocks and funds, systematic investments, portfolio rebalancing and loss capping through stop-losses.

Suitable small-cap allocation for investors

The ideal allocation to small-cap funds varies based on an investor's risk profile, investment horizon, and portfolio size:

• Conservative Investors: Up to 5% of portfolio
• Moderate Investors: 5-10% of portfolio
• Aggressive Investors: 10-15% of portfolio

Higher allocation limits of 15-20% should only be considered by investors with the highest risk appetite, investment experience and ability to withstand extreme volatility. Those new to small-cap funds should begin with a smaller allocation.

Conclusion

While small-cap funds carry higher risks, they also offer the potential for higher returns over long investment horizons. By understanding the risks involved and using prudent risk management strategies, retail investors can effectively tap into the growth potential of small-cap funds while optimising their portfolios. Maintaining balanced allocation, diversification and long-term outlook are key to maximising risk-adjusted return potential with small-cap investments.

FAQs

Should I stop my small-cap SIPs during market falls?

Avoid stopping your SIPs during market falls. In fact, market corrections provide an opportunity to accumulate more small-cap fund units at lower prices through SIPs. Stay invested

How often should I review my small-cap funds?

Review your small-cap funds at least every six months. Assess portfolio concentration, performance across cycles and peer comparisons. Allow underperforming funds 1-2 years to recover before replacement.

Are small-cap funds only suitable for aggressive investors?

No, moderate investors can also consider allocating a small (5-10%) part of their portfolio to small-caps as part of a diversified strategy and a long-term investment outlook. Conservative investors who want to take equity exposure as well may restrict to less than 5% allocation.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.