Outstanding Performance in 2023
As of December 6, 2023, small-cap funds have shown a remarkable 40% growth over the year, significantly outperforming other categories. This growth is substantial, especially when compared to mid and large-cap funds. The Nifty Midcap Index reported 38% returns.
At the same time, the Nifty 50 Index, representing large-cap stocks, showed only 12% returns in the same period. This exceptional growth in small-cap funds highlights their potential for high returns in this category.
Driving Factors that Fueled Small Caps
Several factors have contributed to the success of small-cap funds in 2023. Key among these is the strong representation of sectors like manufacturing and exports, which are closely tied to the domestic economy and benefit from India’s growing economic opportunities and government support. Additionally, disruptions in commercial real estate, regional banks, and IT service providers have opened new opportunities for small-cap investments.
The Role of Domestic and Foreign Investors
The surge in small-cap funds is partly due to robust domestic investment flows, contrasting with the lesser activity of Foreign Portfolio Investors (FPIs) in the Indian stock market. This trend underscores domestic investors’ significant influence in driving the performance of these funds.
Volatility and Risk Considerations
Despite their volatility, small-cap funds have historically demonstrated resilience. For example, the Russell 2000 Index, flat for the first five months of 2023, surged in June and July, returning over 10% year-to-date by mid-August. Furthermore, when small caps have traded at substantial discounts relative to large companies, they have historically delivered double-digit returns over the following 12 months and outperformed large caps in almost all past periods.
Investor Behavior and Market Trends
High-quality small caps with good products have become particularly attractive due to waning investor interest and declining analyst coverage, creating a favourable setup for these companies. Moreover, the unique composition of small caps, such as a more significant industrial sector and less overseas exposure than large companies, presents distinct investment opportunities.
Small Caps in the Broader Economic Context
The US economy’s resilience, especially the consumer sector, has been a significant factor in the performance of small-cap funds. Companies like Fox Factory, which benefits from sturdy consumption in sectors like off-road vehicles and motorbikes, exemplify the strength of consumer-driven small caps. Additionally, the robust labour market in the US, with unemployment still below 4% as of July 2023, suggests potential value in professional staffing businesses catering to long-term growth sectors like technology.
Large Cap Funds: Potential for a Comeback
The Indian stock market has also seen the return of Foreign Institutional Investors (FIIs), especially as India’s GDP growth has beaten estimates. This could signal a potential comeback for large-cap funds, traditionally seen as more stable and less volatile than small-cap funds.
Final Thought
The performance of small-cap funds in 2023 has been impressive. Still, investors need to approach these funds with a balanced perspective. While they offer the potential for high returns, the associated risks must be addressed. A thorough understanding of market trends, sector dynamics, and individual risk tolerance is crucial before investing in small-cap funds. Investors should also consider the resilience of the US consumer and ongoing trends in areas like the labour market and technological disruption to make informed decisions.
(Chakrivardhan Kuppala is Co-founder and Director at Prime Wealth Finserv. Views are own)
