Investors bet big on small cap funds — analysts decode possible reasons

"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," he told CNBC-TV18.com.

Currently, 24 small-cap funds are available for investment across various asset management companies (AMCs). AMFI, in consultation with SEBI and stock exchanges, prepares the list of stocks at six-month intervals. The cutoff market capitalisation for being considered a small-cap company as of December 2022 was Rs 16,474 crore.

"An updated list based on market cap will be released by AMFI at the end of June 2023," Kavalireddi said.

According to Kavalireddi, small-cap funds have delivered 10 percent return on a year-to-date (YTD) basis, an 11.5 percent return on a three-month basis, and a 24.4 percent return on a one-year basis. Nippon India Small Cap Fund, the largest small-cap fund based on AUM, delivered a 13.5 percent return on a YTD basis, equally matched by Franklin India Smaller Companies Fund at 13.3 percent.

Among the funds with smaller AUM (< Rs 1,000 crore), Mahindra Manulife performed exceedingly well, delivering a return of 13.6 percent during the same period. Take a look:

If we look at historical numbers, small caps have outperformed large caps by a margin and valuations look reasonable. According to Arihant Bardia, CIO and Founder at Valtrust, over a 10-year period the small cap index has delivered much better rolling returns than large caps.

"Moreover, unlike large caps several active funds have consistently delivered alpha in small caps. This clearly sets a case for investing in small caps," he said.

In general, equity mutual funds carry considerable risk, with small-cap mutual funds being more risky and accompanied by highly volatile returns.

Hence, Kavalireddi said small-cap funds are better suited for investing to meet financial goals at least five years away.

"While small-cap funds offer considerable scope for wealth building, aggressive or long-term investors with higher risk appetite and the ability to withstand large drawdowns during market corrections can invest in these funds," he added.

Considering the risk appetite of an investor, Anurag Jhanwar, Co-Founder and Partner at Upwisery Private Wealth said investors should choose to allocate 10-15 percent in small caps and consider it as the satellite portion of the portfolio.

"It is advisable to have exposure to small caps through active route, as all the stocks below 250th rank by market capitalisation fall in the small-cap basket. The sheer size of the small-cap universe allows fund managers to deliver consistent and superior returns with minimum overlap. The stock selection here varies as per fund manager investment style and evaluation criterion. It is important to understand the same and ensure that the investor is comfortable with the investment thesis and inherent risk," he said.

The ideal way to opt for small-cap exposure, Jhanwar added, is through creating a basket of 2-3 funds and investing through SIPs. While creating this basket, a detailed evaluation on risk return parameters and fund managers ability to deliver should be evaluated.