Influx of flows, upsurge in retail investors' participation and bullish market conditions have boosted the assets for the small-cap mutual fund category to Rs 2.43 lakh crore mark at the end of March 2024, marking an 83 per cent surge compared to the previous year.

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The surge in assets was complemented by an increase in the number of investors, with the number of folios reaching 1.9 crore in March 2024 from 1.09 crore a year ago, adding an investor base of 81 lakh. This shows investors' inclination for small-cap funds.

Gopal Kavalireddi, Vice President - Research at FYERS, said that the growth trajectory of India's economy is attracting increased interest, leading many unlisted small-cap firms to seek support from the capital market. This trend offers promising opportunities for investors eyeing long-term growth prospects.

However, factors such as General Elections, monsoon forecasts, economic activity, inflation, GDP projections, and FY25 earnings growth are likely to influence small-cap company valuations and induce volatility in this segment, he added.

In the financial year 2023-24, small-cap funds witnessed an inflow of Rs 40,188 crore, way higher than the Rs 22,103 crore inflow seen in the preceding fiscal.

However, the month of March saw small-cap funds witnessing a net outflow for the first time in over two years at Rs 94 crore.

This came after markets regulator Sebi, in late February, raised concerns over froth building up in the small and mid-cap funds and directed mutual fund houses to put in place a framework to safeguard the interest of investors, who invested in these funds.

The concerns came in the backdrop of huge flow in the small and mid-cap schemes of mutual funds over the past few quarters.

According to the data from Association of Mutual Funds in India (AMFI), the asset under management (AUM) of the small-cap mutual fund hit its peak of Rs 2.43 lakh crore at the end of March 2023 as compared to Rs 1.33 lakh crore in March 2022.

Kavalireddi attributed the huge surge in assets to several factors such as attractive returns, positive investors' sentiment, portfolio diversification and a rise in retail participation.

"Smallcap index itself has grown 60 per cent in FY24, accounting for the majority of the growth in AUM," Jay Shah, Founder and CEO of Finwisor, said.

Also, the current positive sentiment among investors, bolstered by strong economic activity and earnings growth, has been a key factor driving increased allocations towards small-cap funds.

Moreover, small-cap funds gained traction as an attractive element of diversified portfolios, benefiting from their potential for significant growth and undervaluation observed in FY23, amid the influx of investments into equities.

Overall, the AUM of equity-oriented mutual fund categories jumped 55 per cent in fiscal 2024 to Rs 23.50 lakh crore, led by strong inflows and mark-to-market gains. The category saw net inflows of Rs 1.84 lakh crore in FY24, up from Rs 1.47 lakh crore in the previous fiscal.

Under Sebi's rule, in small-cap mutual funds, fund managers are required to invest at least 65 per cent of their portfolios in small-cap stocks.

Looking forward to FY25, Finwisor's Shah said, "Smallcap returns have not just been an outcome of market sentiment, but also fantastic earnings growth. However, it has been historically observed that periods of euphoria are followed by periods of low returns. Accordingly for FY25, the likelihood of negative to low returns is the highest".

Although small-cap funds offer appealing growth prospects, these are marked by elevated volatility, reduced liquidity, unpredictable market risks, and limited research coverage.

Therefore, industry experts suggested that it's crucial for investors to thoroughly assess their risk tolerance and investment horizon before contemplating investments in this segment.