The Nifty index hit a new high on Monday, marking a strong start to the week. Many stocks hit new 52-week highs. However, the small-cap index is still hovering below the previous high. Many investors, especially retail investors, invest in these stocks directly or through mutual funds.

Investing in high-quality small-cap stocks has benefited many long-term investors in the past. After the first-tier stock indexes started to go north, many people expected that small-cap stocks would follow suit. Many began to view them as relatively low-level, long-term bets. In addition, the new fund offering of the Mahindra Manulife Small Cap Fund will also start on November 21.

Most investors view small-cap stocks as high-return bets. But they were also very volatile, and making money on them required buying relatively cheap things, and the economy was expanding then. While economists are likely to continue to debate real interest rates, it seems certain that the Indian economy will post solid growth despite rising interest rates. Small-cap stocks with strong underlying businesses and healthy balance sheets could benefit from a broad-based economic recovery.

Stocks rose after India’s pandemic-induced lockdown. Despite the recent stock market correction, it’s still far from cheap. Investors need to see them in the context of relative valuations.

While many investors see small-cap stocks as an entry into the high-growth, high-volatility, and high-return realm, many oppose them, citing poor liquidity. However, things have changed after the Securities and Exchange Board of India (SEBI) classified mutual fund schemes. Small-cap stocks include all stocks ranked 251 through 500 by market capitalisation. Smaller funds must invest at least 65% of their capital in stocks of these companies.

Small-cap stocks offer exposure to sectors such as capital goods, services, textiles, sugar and chemicals that may not be available to large-cap stocks.

Over the three years ending November 25, 2022, the small-cap fund returned 30.16% but gained only 0.32% in fiscal 2022. While the numbers over the three years look good, the variance in returns offered by individual small-cap schemes cannot be ignored. While the best-performing scheme, Quant Small Cap Fund, returned 51.54%, the worst-performing scheme, Aditya Birla SunLife Small Cap Fund, returned 19.72%. According to Value Research, mutual fund houses manage Rs 1.32 lakh crore in assets across 32 dedicated small-cap schemes.

CRISIL recently noted that the size of these projects has increased since the March 2018 classification. The size of the largest micro fund at that time was Rs 7,007 crore, which has grown to Rs 22,158 crore by September 2022. The study added that fund size cannot be the only factor determining the scheme’s performance. While small fund sizes have traditionally been thought to help fund managers remain nimble, it doesn’t necessarily help performance. Mid-cap small funds fared better, with a compound annual growth rate (CAGR) of 11.2% over the same period, compared with returns of 10.9% for small funds and 9.7% for large funds.

Investing in small-cap funds can be a good idea if you can live with the volatility. Investing in small-cap funds shouldn’t be your first investment in mutual funds. Since these schemes can be more volatile than large-cap stock funds, you can steer clear of them if you’re uncomfortable with high volatility. If you’re looking for moderate exposure to small-cap stocks, multi-cap and flex funds may be better. Even if you’re sure you can afford to hold small-cap funds, limit your exposure to a maximum of 20%.

Within the equity asset class, allocate conservatively to small-cap funds with strong long-term track records.