The past few weeks have brought significant turmoil to the small-cap sector within the Chinese stock market, particularly among stocks labeled as "ST" (special treatment). Many funds that are heavily invested in small-cap stocks have witnessed substantial declines in their net asset values.

Taking stock-type ETFs as an illustration, data from Choice reveals that from May 20 to June 4, multiple instances show a sharp downturn in a variety of small-cap indicesNotably, the CSI 2000 Index, representing small-cap stocks, averaged a decline exceeding 7%, apart from industry-themed ETFs.

In this context, the discussion surrounding the investment viability of small-cap stocks has reignited

Investors are grappling with whether these stocks represent an opportunity or a liability amidst sharp downturns.

Falling from Grace

Once a favored terrain for short-term traders, the small-cap sector is now facing an exodus of capital as many opt to steer clear of these precarious stocks.

Since the introduction of new regulatory measures known as the "Nine National Regulations," a survival-of-the-fittest phenomenon has been intensifying within the A-share marketNumerous listed companies have been subjected to delisting warnings or other risk alerts, resulting in over 15 companies being either deregistered or facing imminent delisting

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The performance of the small-cap sector has suffered particularly amid this climate, with numerous ST stocks plunging to their lowest limits consecutively.

The sharp decline in ST shares has undoubtedly cast ripples across the broader small-cap marketAs of June 5, the Dongcai small-cap index experienced a substantial drop of 13.51%, whereas larger indices such as the Shanghai Shenzhen 50 and the CSI 300 only retracted slightly over 2% during the same period.

Since the Lunar New Year, small-cap stocks have exhibited a distinctive "M" pattern in their trajectoryA rebound began on February 17, peaked on April 2, followed by a decline until a brief rebound around April 22, only to enter another downtrend starting from May 20.

As a result of these developments, the performance of funds that are heavily invested in small-cap stocks has varied significantly

For instance, within this timeframe, apart from sector-themed ETFs, several of the CSI 2000 ETFs also suffered close to a 7% dropAdditionally, certain actively managed funds focused on small-cap stocks have seen declines surpassing 5%.

Moreover, the annual performance trends illustrate that funds adopting small-cap strategies have not managed to maintain a sustained rebound, unlike their larger-cap counterparts such as the CSI 300 ETF, which have coped better with market fluctuations.

Challenges in Investment

Is the era of speculating on small, underperforming stocks behind us?

In light of the recent plummet of ST stocks, discussions about whether to invest in small-cap stocks have resurfaced

Many argue for a cautious approach, pushing investors to distance themselves from small and low-quality stocks while leaning towards value blue-chip stocksHowever, some experts advocate for certain small-cap stocks exhibiting potential for future growth, cautioning against dismissing them solely due to their small market size.

According to Zheng Yanxin, a fund manager at Quan Jing Fund, ST stocks and poorly performing shares dominate the small-cap sectorRecently, intensified scrutiny by regulatory bodies concerning financial malpractices has caused fluctuations in stock prices, leading investors to adopt a wait-and-see approach and creating a negative feedback loop.

While small-cap stocks may not be suitable for speculative trading, they still harbor investment opportunities

Zheng advises investors to return to the fundamentals of investing, suggesting specific analysis for each case, and to focus on selecting quality stocks rather than engaging in price speculation.

Sun Enxiang from Paipai Wang wealth management highlights that the recent downward trajectory of small-cap stocks is primarily linked to three factors.

Firstly, there’s been a transition in market sentimentIncreased uncertainties have pushed investors towards seeking stable cash flows and dividends, increasingly favoring high-dividend stocksRecently, an influx of nearly a hundred listed companies announced mid-term dividends, boosting the appeal of high-dividend sectors while simultaneously driving capital away from small-cap stocks.

Secondly, market sentiment has played a pivotal role

The announcement of the new "Nine National Regulations" has fostered a clear risk-averse attitude towards small-cap stocks among investors, which has placed added pressure on the small-cap market.

Lastly, product redemptions have also come into playAs various factors induce a decline in net asset values, numerous investors opt to redeem their products, consequently selling off illiquid small-cap stocks and adding to the downward pressure.

Whether investing in small-cap stocks or related funds, the prospect of high returns comes bundled with significant risksAccording to Sun Enxiang, due to their small market cap, weak liquidity, and greater susceptibility to market emotions, small-cap stocks are better suited for swing trading