Understand how market cycles impact the performance of small cap funds

A small cap MF (mutual fund) invests in the stocks of small-cap companies. These companies have a market capitalisation below Rs 5,000 crores and are ranked 251st and beyond in terms of total market capitalisation. A small cap fund allocates at least 65% of its investments to small-cap stocks.

Small-cap companies are often young businesses, including startups or firms that have just rolled out and are on their way to establishing themselves. Because they are new, these companies come with increased risk and can be more vulnerable to market fluctuations.

Let’s understand more about how small cap funds are influenced by market cycles.

Understanding market cycles

The market operates in two primary cycles - bull and bear. A bull market occurs when the market rises by more than 20% from its lowest point. Returns tend to improve during this time, and companies often see higher profits.

On the other hand, a bear market is marked by a decline of more than 20% from the most recent peak. This indicates a downturn in market performance.

How do market cycles affect small cap returns?

Since small cap funds invest in smaller businesses that are not stable yet, they may experience fluctuations when market conditions change. Small-cap companies have more opportunities to grow and earn profits when the market is rising. This leads to higher returns for small-cap mutual funds in a bull market. In contrast, these funds can experience losses during a market downturn, as smaller companies may struggle to generate profits.

Market conditions can also impact investor sentiment, which can either boost or restrict the performance of small-cap funds. In a bear market, investor optimism typically decreases. This can have an even greater impact on small-cap funds, as these companies may face challenges in securing financing. Without access to capital, their growth potential becomes limited. On the other hand, in favourable market conditions, small-cap companies are more likely to obtain the funding they need for expansion, which can result in better returns for small-cap funds.

Additionally, small-cap mutual funds invest in stocks that are less liquid. This can make buying and selling more difficult for small cap funds during times of market unrest and further complicate the performance of these funds.

How can you lower risk in small cap mutual funds during different market cycles?

While you cannot completely eliminate the risk associated with a small cap fund, you can implement some strategies to minimise it:

• Keep a long-term investment horizon: Small cap funds are suitable for investors who have a long-term investment horizon. With a longer investment horizon, you can better handle market ups and downs. Short-term volatility can lead to declines in small cap indices, as seen during events like the COVID-19 pandemic, which negatively impacted small cap stocks. However, holding your investments for longer can help you ride out these short-term disruptions and allow your money to grow and potentially recover from market dips. A time horizon of seven years or more is typically recommended to maximise the potential for long-term gains from small cap funds.
• Diversify your portfolio: You can minimise risk by seeking funds with a diversified portfolio across various small-cap sectors. Additionally, you can consider balancing your small cap investments with mid cap, large cap, and multi cap funds. This can reduce the impact of market downturns on your overall portfolio and provide a better balance between risk and return.
• Invest through Systematic Investment Plans (SIPs): Investing through SIPs allows you to invest at regular intervals, regardless of market conditions. Regular contributions to your small-cap investments help you take advantage of different market cycles over time. It results in buying more units when prices are low and fewer units when prices are high, thereby balancing out the impact of market fluctuations.  

Conclusion

Market conditions can significantly impact the average return of small-cap funds, but you can circumnavigate these fluctuations by adopting the right strategies. Maintaining a long-term investment horizon can help you ride out short-term fluctuations. Additionally, investing through SIP and diversifying your investments can also help tackle volatility and create a more balanced portfolio. Having said that, it is important to understand that small-cap funds inherently carry high risk, so being prepared for volatility is crucial.

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