Should you invest in small-cap funds now? | Summary and Q&A

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July 20, 2023
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PrimeInvestor
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Should you invest in small-cap funds now?

TL;DR

Small cap funds have seen significant inflows and outperformance recently, prompting concerns about growth prospects and valuations, as well as liquidity risks associated with smaller stocks.

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Questions & Answers

Q: What are the concerns surrounding investing in small cap funds at this time?

The concerns surrounding small cap funds include the growth prospects and valuations of small cap stocks, as well as the liquidity risks associated with smaller stocks in the small cap category. These concerns have prompted fund houses to curtail inflows and restrict investments in small cap funds.

Q: Why have fund managers stopped accepting lump sums for small cap funds?

Fund managers have stopped accepting lump sums for small cap funds primarily because they want to be cautious about deployment during a market rally. They prefer planned inflows through systematic investment plans (SIPs) to ensure prudent investment entry points and avoid excessive inflows that can affect stock prices.

Q: How does liquidity risk impact small cap funds?

Liquidity risk is a major concern for fund managers in a falling market. If there is a market crash, liquidity can dry up quickly, making it difficult to sell holdings at market price. This can result in funds being forced to sell at a discount, impacting profits. Fund managers carefully manage liquidity by diversifying holdings and avoiding excessive inflows.

Q: Should investors continue to invest in small cap funds for the long term?

Yes, investors can continue to invest in small cap funds for the long term. Despite periods of volatility, small cap active funds have historically beaten the small cap index. However, investors should keep their exposure to small caps relatively low and not allocate more than 15-30% of their portfolio to this segment. Using SIPs and taking advantage of market falls to invest lump sums can be a prudent strategy.

Q: What are the risks associated with small cap funds?

The risks associated with small cap funds include the volatility of the market cap segment, potential underperformance during tough market conditions, and the vulnerability of liquidity in smaller stocks. Prudent portfolio management and diversification are important in mitigating these risks.

Q: How do fund managers manage liquidity in small cap funds?

Fund managers manage liquidity in small cap funds by diversifying holdings, including a mix of large/mid-cap stocks and liquid debt instruments. This helps ensure there is enough liquidity to meet redemptions or sell holdings during challenging market conditions. They also carefully plan inflows through SIPs to maintain a balanced portfolio.

Q: What is the recommended investment strategy for small cap funds?

The recommended strategy for investing in small cap funds is to allocate a relatively low percentage of the portfolio (15-30%) to this segment. Investors should use SIPs for long-term deployment and consider investing lump sums during market falls if opportunities arise. Prudence and careful risk management are key to successful investing in small cap funds.

Summary & Key Takeaways

  • Small cap funds have received significant inflows and have been outperforming large cap funds recently.

  • Concerns arise regarding the growth prospects and valuations of small cap stocks.

  • Liquidity risks associated with smaller stocks in the small cap category are a key concern for fund managers.

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