Think of bull markets as rising tides. In this tide, small cap funds have the potential to rise faster than their large cap counterparts. Small cap funds invest in companies ranked below the top 250 in terms of market capitalisation on recognised stock exchanges. Their leaner balance sheets and evolving business models can potentially translate into outperformance when market sentiment is optimistic. However, this also means higher volatility and business risk—especially during market downturns.
This article explores small cap performance during bull markets, the reasons behind it and if investment in such funds can be suitable for you.
Why small cap funds have the potential to perform better in bull markets
Here are some of the ways in which small cap funds operate that may help generate potential returns during bull phases:
- Growth orientation: Small cap companies are often in the early stages of expansion, with higher potential for revenue and profit growth during economic upswings.
- Market sentiment boost: Bull markets typically bring greater investor optimism, which can favour riskier, high-growth segments like small caps.
- Stronger price momentum: With relatively lower market capitalisation, small cap stocks can see sharper price movements when demand increases.
- Increased investor participation: Bull phases usually attract more retail and institutional investors, expanding liquidity in smaller stocks.
- Agility advantage: Smaller companies may be more responsive to market opportunities, which can enhance performance when business conditions are favourable.
Investors must note, however, that all market caps tend to have periods of outperformance in different phases of the market cycle. Moreover, small cap companies carry higher business and liquidity risks than large and mid caps, making them suitable for investors with a higher risk tolerance and a long investment horizon.
Historical performance of small cap funds during bull phases
- 2009 rebound: After the global financial crisis low, the BSE Small Cap index soared ≈ 115%.
- 2014 and 2017 bursts: Small cap total return indices clocked 71.13% and 60.8% in those calendar years, respectively, ahead of large cap benchmarks.
- November 2023 snapshot: The Nifty Smallcap 250 spiked 10.22% in a single month, versus 6% for the Nifty 50.
Note: While these examples illustrate periods where small caps performed strongly during bullish phases, they do not represent all market conditions. Small cap performance can vary widely, and there have been instances when they did not outperform despite positive sentiment. Investors should view such data points as illustrative rather than predictive, and always consider long-term risk and return characteristics before investing.
Read Also: How to Build a Diverse Portfolio with Small-Cap Mutual Funds
Risk-reward trade-off in small cap fund investments
Potential returns
- Higher growth potential: Small companies often operate in emerging sectors or niches and may scale revenue and earnings faster than mature firms.
- Early-stage advantage: Investors in small caps can benefit if the business becomes a future market leader.
- Alpha generation: Skilled fund managers may uncover undervalued small caps, offering the possibility of returns above the broader market.
Risks to Consider
- High volatility: Small cap stocks tend to experience sharper price swings due to lower trading volumes and sensitivity to news or earnings surprises.
- Liquidity concerns: In turbulent markets, small cap stocks may be harder to buy or sell without impacting the price, which can affect fund performance.
- Business fragility: Smaller companies may face greater challenges in economic downturns, such as limited access to credit, weaker cash flows, or operational instability.
- Longer recovery periods: Small caps can take longer to bounce back after market corrections compared to large caps, testing investor patience and discipline.
Read Also: Should I start an SIP in Small cap fund?
How to choose a suitable small cap fund
When evaluating different small cap funds, here are some things to look out for:
- Expense ratio check: The higher the expense ratio, the lower your net potential returns.
- Consistency of performance: Schemes that have shown relatively consistent performance may be less risky than those with spurts of outperformance. (Past performance may or may not be sustained in future).
- Risk-adjusted returns: Check metrics such as Sharpe ratio and Information ratio to assess how much risk was taken to achieve returns delivered over a certain period. Schemes with a more optimal risk return balance may be more suitable.
- Manager track record: Check the fund’s managers credentials, experience and investment strategy.
Considerations for investing in small cap funds during market upswings
- Stagger entries: Consider using SIPs or make lumpsum instalments in phases to mitigate market timing risk.
- Set rebalancing bands: Trim exposure if allocation doesn’t align with your risk tolerance.
- Monitor valuations: Keep an eye on forward Price-to-Earnings (P/E) gaps between small and large caps; extremes can potentially precede corrections.
Should you include small cap funds in your portfolio?
Small caps may suit investors who:
- Maintain at least a five to seven year investment horizon.
- Are able to withstand sharp interim drawdowns without selling in panic.
- Look for an equity accelerator in combination with relatively stable large cap or hybrid exposures.
Conclusion
Experience demonstrates that small cap funds in bull markets have the potential to outperform bigger counterparts due to operating leverage, valuation re-rating, and liquidity tailwinds. The same characteristics, though, can potentially amplify volatility during corrections. A balanced mutual fund bull market strategy combines disciplined entry, cyclical rebalancing, and prudent fund selection to maximise the gain potential on the way up while mitigating losses on the way down.
FAQs:
Why do small cap funds perform well in bull markets?
Boosted earnings growth and valuation re-rating can potentially boost returns when sentiment is positive.
Are small cap mutual funds suitable for long-term investment?
They can be suitable for long horizons provided you have a very high risk appetite and can weather higher volatility and sharp drawdowns.
What are the risks of investing in small cap funds during a bull run?
More price volatility, liquidity pressures, and possible over-valuation at the top of the cycle are some of the risks.
How can I identify the better performing small cap funds?
Compare long-term rolling returns, expense ratio, manager tenure, and size of AUM; avoid chasing short-term chart leaders.
Is it wise to increase allocation to small cap funds in a growing market?
Only if your overall asset mix remains aligned with risk tolerance; consider incremental rather than sweeping changes.
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