The overall quality of publicly traded small caps has deteriorated, as private sponsors help top performers stay private for longer. Instead of small caps, investors should consider actively adding exposure to U.S. large-cap value and mid-cap growth stocks.
Yes, it is prudent to invest in small-cap mutual funds if you have a high risk tolerance and a long-term horizon (7-10 years). They offer higher growth potential but come with more volatility. Ensure they form a part of a diversified portfolio to balance risk.
However, investors also need to be aware and take into account the risks associated with small-caps viz. higher volatility, lower liquidity, lesser disclosures and transparency. Moreover, small-caps also are likely to be more vulnerable to economic downturns.
The small-cap funds saw an average return of 25.69% from December 2023 to December 2024, while mid-cap and large-cap funds yielded returns of 26.91% and 14.97% during the same period. So far, the Sensex has gained 8.92% and the Nifty has risen 9.49% in 2024.
Given the changing macroeconomic backdrop, we outline why we see potential value for investors in small caps in 2024. The consensus is that interest rates look to have peaked, with markets now pricing in cuts across many major economies in 2024, something which could prove beneficial to small caps.
Most investors think smaller companies underperform in a recession. In most cases, they are correct. However, what's less well-known is that small caps usually exit recessions quicker than assumed – outperforming large caps. This rebound can begin as early as three months into an economic downturn.
Small-caps, on average, outperform large-caps by about a percentage point for the six months after a 50 basis point cut, she writes, and the majority of those periods see small-caps outperform by any degree. They average about three percentage points of superior returns over the 12 months following such a rate cut.
Short-Term Investor. If you are investing in mutual funds for a short duration, stay away from small-cap mutual funds. Small-cap mutual funds perform well over a long period of time. However, over a short period of time, they tend to be very volatile.
Nifty Smallcap 100 index has fallen 4% to its lowest level since mid-June amid concerns about Q3FY25 performance. Disappointing earnings results have led to increased selling pressure, with many stocks down significantly from their 1-year highs and foreign investors pulling out funds.
We expect small-cap earnings growth could exceed that of large-cap stocks in 2025, aided by easier earnings comparisons.
Small-cap valuations – Attractive
We expect earnings to drive the next leg higher for small-cap share prices. Analysts are looking for robust earnings growth: 15% this year, and by over 30% in 2025 and 2026. That is ahead of the long run rate of 13% growth (see Exhibit 3).
The small cap segment can be extremely volatile in the short term, but they have the potential to offer very high returns over a long period. Small cap schemes are recommended only to aggressive investors with a high-risk appetite and long investment horizon, say, around seven to 10 years.
Market experts recommend that investors hold small caps for at least 10 years to benefit and allocate 8% of the portfolio to small caps. But this is entirely subject to the risk appetite and investment goals of the investor.
Since the start of 2023, the S&P 600 small-cap ETF has advanced around 25% as of the time of this writing. That's not bad for a roughly two-year period. But the S&P 500 index (^GSPC -1.54%) is up about 50%, or roughly twice as much. That's a massive outperformance on the part of the large-cap S&P 500 index.
Key Benefits of Small-Cap Investing:
Diversification - lower correlation to large-caps improves overall portfolio efficiency. Growth potential - younger, faster growing companies earlier in life cycle. Sector/Industry breadth - wider array of sectors and industries compared to large-caps.
The main disadvantage of a small-cap fund is its higher risk profile, making it susceptible to market volatility and economic downturns.
Hence, it is important to have a long-term investment window while investing in Small-Cap Funds so that you give sufficient time to your investment to generate returns. The recommended time frame is eight to ten years. Making these funds highly suitable for long-term investors.
Why not to invest in small-cap? -Small-cap is known for its volatility or sharp price fluctuations leading to greater uncertainty and risk for investors. Moreover, they also have liquidity concerns, limited resources and stability, and higher rates of failure.
The broadening of the market and the prospect for rate cuts during the rest of 2024 may serve as tailwinds for small-caps. In addition, small-cap earnings growth is expected to outpace large-caps as we head into 2025. With that in mind, we've honed our outlook for the asset class.
Investing in small caps during recessions has generated superior investment returns, according to our back-testing of the data to the late 1980s (see Table 1, below).
The difference between large-cap, mid-cap, and small-cap mutual funds lies in risk, returns, and liquidity. Mid-cap funds offer moderate volatility and liquidity, small-cap funds are highly volatile with lower liquidity, while large-cap funds provide steady returns with minimal volatility, averaging 7% over five years.
Small-caps are making a comeback in 2024, with the Russell 2000 index up 17% this year, though it still lags the S&P 500.
In a recession, it's smart to preserve your capital by investing in safer assets, such as bonds, particularly government bonds, which can perform well during economic downturns.
Inflation and small-cap performance through the decades
We found that the MSCI World Small Cap Index outperformed the MSCI World Index by 0.47% per month in periods of low inflation (CPI < 2%) and by only 0.09% in periods of high inflation (CPI > 2%).