Small cap funds remain investors' favourite in June: What's driving the rally and will this trend continue

"Investors have been consistently investing in small-cap funds for a couple of years. The last time this category witnessed net outflows was September 2021," he said.

Interestingly, of the total net flow of Rs 1.46 lakh crore into equity-oriented schemes, 15.1 percent or Rs 22,104 crore was invested in small-cap funds in FY23.

According to Mukesh Kochar, National Head-Wealth at AUM Capital Market, the major reason for strong inflows in small-cap funds could be the valuation gap between small-cap companies and large-cap companies.

"This always happens when markets become a little expensive but the fund flow chases stocks. In such type of market, fund managers try to find out values or pockets of opportunities on a comparable basis that are available at the lower end of the radar. These stocks are with a low base and can grow at a higher pace compared to large companies in terms of percentage growth and are undiscovered stories. Hence, higher risk and higher reward. The massive fund flow via mutual funds, PMS or direct equity investors has added more momentum to it," Kochar said.

If we look at the performance of small-cap funds in the mutual fund space, the 5-year CAGR is around 18-21 percent, 3 years is at 40-45 percent and 1 year is at 30-37 percent. Even in the last 6 months, they have given a return of around 12-15 percent absolute.

"So, when fund performance improves or outperforms, money chases and vice versa," he said.

Small-cap funds have the added advantage of offering better opportunities as the investment universe is much larger compared to large or mid-cap funds. Currently, 24 small-cap funds are available for investment across various asset management companies (AMCs).

The small-cap fund flow trend may continue for some time, Kochar said.

"This always happens when the market is at its peak and there are some concerns over valuation but liquidity is chasing the long-term India story. Fund managers try to find value stocks with more legs of opportunity. Retail money chasing the market is at an all-time high and at the same time HNIs and family offices are flushed with liquidity, which generally follows market trends. Currently, the trend is in favour of small-cap funds," he said.

NIPPON small cap, HDFC small cap and SBI small-cap have done well consistently within small cap fund space. Most of these funds follow value strategies as this segment is all about value but these fund managers tried to buy value with growth and that has paid off well.

"Most of these funds have grown heavily in size and are currently between Rs 20-30k crore of asset under management (AUM)," Kochar said.

The challenge now lies in managing such a large size of funds in small cap space due to small floating stocks and liquidity. While investors have been buoyant to invest in this, some mutual fund companies have recently opted to limit the flows in the small-cap category perhaps due to concerns regarding valuations and difficulty to deploy money without affecting their performance.

Nippon India Small Cap Fund became the third small cap fund which stopped accepting fresh investments after SBI Small Cap Fund and Tata Small Cap Fund.

Experts say that investors should moderate return expectations going forward and should consider the small-cap category for five year plus time horizon with a proper asset allocation framework.