Small-cap mutual funds: How much should you invest? Experts recommend 10-20% allocation, warn against excessive exposure

Small-cap mutual funds can offer investors exposure to emerging businesses with the potential to become tomorrow’s mid-cap and large-cap companies. However, their higher growth potential comes with greater volatility, making portfolio allocation particularly important.

Financial experts recommend keeping small-cap funds as a satellite allocation rather than making them the core of an equity portfolio. The appropriate allocation depends on an investor’s financial goals, investment horizon and ability to withstand market volatility.

Rahul Jain, President and Head of Nuvama Wealth Management, said investors with a high risk appetite and an investment horizon of more than five years can consider small-cap funds as part of their equity portfolio.

How much should you invest in small-cap mutual funds?

For most investors, allocating 10-15% of their equity portfolio to small-cap schemes can provide exposure to the segment without making the overall portfolio excessively vulnerable to market volatility.

Vaibhav Porwal, Co-Founder of Dezerv, suggested a slightly higher allocation of 10-20% of total equity exposure for most portfolios, with 25% serving as an upper limit.

“Small-cap allocations function like strong spices in a meal: a controlled amount enhances the overall outcome, but an excess can make it unpalatable,” Porwal said.

He added that investment timelines and downside tolerance should determine the allocation rather than age alone. For instance, a 55-year-old investing towards a goal 15 years away may be able to accommodate a higher small-cap allocation than a 30-year-old planning to purchase a house within three years.

Vaibhav Chugh, CEO of Abakkus Mutual Fund, also recommended a 10-15% allocation, while emphasising that investors should assess their risk profile and investment horizon before deciding how much to invest.

He said small-cap funds have inherent volatility despite their long-term growth potential, making it important for investors to determine their exposure based on their individual circumstances.

Should first-time investors invest in small-cap funds?

First-time mutual fund investors do not necessarily need to begin their equity investment journey with dedicated small-cap funds. Experts suggest building a diversified portfolio through flexi-cap, multi-cap or index funds before considering a separate small-cap allocation.

Jain said first-time equity investors could begin with a flexi-cap fund, which invests across large-cap, mid-cap and small-cap stocks depending on market conditions. This provides some exposure to smaller companies without requiring investors to select a dedicated small-cap scheme immediately.

Once investors gain experience and become comfortable with market fluctuations, they can consider adding a small-cap fund to their portfolio.

Porwal also recommended treating small-cap funds as a satellite allocation. A core portfolio comprising large-cap, flexi-cap or index funds can provide the foundation, while a smaller allocation to small-cap companies can add growth potential.

He pointed out that smaller companies are tracked by fewer analysts and institutional investors, potentially creating opportunities for active fund managers to identify businesses that the broader market has undervalued.

For first-time investors, Chugh recommended systematic investment plans (SIPs) as a way to enter the small-cap segment gradually. Investing through SIPs can spread purchases across different market levels while allowing investors to understand the segment’s volatility before increasing their exposure.

Ranjit Bhatia, Head of Manager Research, Investment Risk and Product Strategy at WhiteOak Capital, cautioned that first-time investors should have an adequate emergency fund, an investment horizon of at least five to seven years and the ability to tolerate a 30-40% fall in their investment before considering dedicated small-cap exposure.

How much can small-cap funds fall during a market correction?

Investors entering small-cap funds should be prepared for substantial losses during market downturns. The segment’s higher growth potential comes with greater volatility, and corrections can be significantly sharper than those in large-cap stocks.

Porwal said small-cap stocks can decline around 30% during a normal correction and 50-60% during a severe downturn. He noted that the Nifty Smallcap 100 has fallen more than 30% from its previous highs in past market cycles.

Bhatia said investors should mentally prepare for drawdowns of 30-50% during severe corrections. He recommended sizing their small-cap allocation so that even if this portion of the portfolio loses half its value, their overall financial plan remains unaffected.

Jain cautioned that some small-cap stocks can fall 20% in a single day during challenging market conditions. Companies with weak fundamentals may lose 50% of their value within a few days and take years to recover.

Chugh said it is difficult to predict the extent of losses because smaller companies are often less researched and can experience sharper price swings. Investors should therefore diversify across multiple stocks and mutual funds rather than depend on a narrow set of small-cap investments.

How should investors manage their small-cap exposure?

Investors should avoid treating small-cap funds as standalone investments and instead assess them as part of their overall asset allocation.

One way to manage the risks is to diversify across market capitalisations instead of concentrating investments in smaller companies. Large-cap and flexi-cap funds can form the core of an equity portfolio, with small-cap schemes providing additional exposure to emerging businesses.

SIPs can also help investors spread their investments over time rather than committing a large amount at a single market level. However, they do not eliminate the risk of losses during market corrections.

Bhatia said the objective should be to determine an allocation that allows investors to remain invested even during sharp declines, rather than forcing them to sell at unfavourable market levels.

Ultimately, small-cap funds should complement an investor’s broader portfolio rather than dominate it. Maintaining a disciplined allocation, diversifying investments and matching exposure to one’s risk appetite can help investors participate in the segment’s growth potential without taking disproportionate risks.