How market timing can influence small-cap fund returns, shows study

Small-cap investing may require a more tactical approach than a traditional buy-and-hold strategy, according to a new report by Share.Market by PhonePe, which found that the segment’s long-term return advantage over large-cap stocks has been relatively modest despite significantly higher risk.

The platform’s latest CRISP Mutual Fund Scorecard, based on an analysis of 20 years of historical data comparing the Nifty Small Cap 250 TRI and the Nifty 100 TRI, found that small caps delivered annualised returns of 12.54%, compared with 11.72% for large caps.

The report noted that investors earned an additional 0.82 percentage points in annual returns while taking on considerably higher volatility. Annualised volatility for the small-cap index stood at 28.81%, compared with 21.06% for the large-cap benchmark.

According to the study, small-cap performance has been highly cyclical, with returns varying widely across market phases. Over rolling three-year periods, small caps outperformed large caps by as much as 20.52% during bullish phases but underperformed by up to 17.16% during market corrections.

Based on these findings, the report said that timing and valuation considerations may play a larger role in small-cap investing than commonly assumed. It also cited a negative correlation between past and future three-year relative performance of small caps versus large caps, suggesting that periods of strong outperformance have often been followed by weaker relative returns.

The scorecard said recent market corrections have narrowed the performance gap between small- and large-cap segments and brought valuations closer to historical norms. It added that investors should focus on fund selection and consistency of performance when investing in the small-cap category.