All You Need To Know About Small-Cap Funds

Small-cap funds have a larger universe of stocks as compared to large-cap and mid-cap. This allows them to invest in stocks that are undiscovered, which in turn allows them to get more returns as compared to large-cap and mid-cap funds. However, it also involves more risk. DSIJ elaborates on all that you should know about small-cap funds.



There are around 5000 companies that are listed in the stock exchanges in India, and out of them, around 93 per cent of the companies fall under the small-cap category, according to the latest market capitalisation data available from AMFI (Association of Mutual Funds in India). These have a market capitalisation which ranges from `0.02 crore to `8518 crore. Small-cap funds have a larger universe of stocks to select from when compared to large-cap and mid-cap funds. So, there is a lot more probability that fund managers may find stocks which are still undiscovered by the market and hence can create alpha for its investors.

According to SEBI's (Securities and Exchange Board of India's) circular on recategorisation, small-cap funds are those that invest minimum 65 per cent of their total assets in equity and equity-related instruments of small-cap stocks. Even with respect to the universe of stocks, SEBI has defined it as any company that falls on or beyond the 251st company in terms of full market capitalisation. The objective of an open-ended equity small-cap fund is to predominantly invest in small-cap stocks.

The small-cap funds have on an average generated 15.5% in a 10-year period compared to large-cap funds, which have generated 11.1%. This always puzzles investors, who are always curious about the exceptionally higher returns that these funds generate over a longer period of time. However, an investor should also understand the high risk involved while investing in small-cap funds. So, before investing in small-caps, it is very important to take into consideration not just returns but also the risk involved.

To understand how the small-cap funds are performing, we have done an analysis wherein we have calculated the average rolling returns of the funds as well as the benchmarks for the period of 1-year, 3-year and 5-year. This would help us understand the consistency with which these funds have performed with respect to their benchmarks. As far as benchmark is concerned, we have considered Nifty Small Cap 100 index and S&P BSE Small Cap index. We have deliberately excluded those small-cap funds that did not have 5 years of history, so that a smaller period time-frame does not tilt the result in a particular direction.



If we look at the above bar graph, then almost 75 per cent of the small-cap funds have outperformed Nifty Small Cap 100 and S&P BSE Small-Cap. Only three out of 12 funds have underperformed the benchmarks. The benchmarks are plotted towards the extreme right of the graph. The line in-between the graph is drawn to understand how many funds have beaten the maximum average returns of the benchmarks. We can clearly see that 9 out of 12 funds that have beaten the benchmarks in 1-year, 3-year as well as in 5-year average rolling returns. The funds that have performed best in our study period is SBI Small Cap fund and Sundaram Small Cap fund. These funds have outperformed their peers and indices in every time frame.

The above analysis is about the average returns and may not present the complete picture. Therefore, we dig the numbers further to understand the distribution of these returns in three time frames, that is, one-year, three-year and five-year rolling returns. We did this study for the period between November 2013 and June 2019.



The above table explains the distribution of returns by various funds in one-year rolling period. Looking at the above table, it is difficult to say clearly the chances of getting a particular return as returns are distributed evenly. However, SBI Small Cap fund does give some indication of better performance, as in the 1-year period in our study, around 52 per cent times it has generated returns of more than 30 per cent. But, for other funds, it is almost evenly distributed. Not just funds, even the benchmark is not giving any clear indications.



When we look at the 3-year rolling returns table, we can see that we get a somewhat clear picture about the returns. Here we can see that there are around 66 per cent chances that Axis Small Cap fund can give returns between 10 per cent to 20 per cent CAGR in 3-year period. There are around 59 per cent chances that HDFC Small Cap fund can give CAGR between 20 per cent to 30 per cent CAGR in 3-year period. The chances for ICICI Pru Small Cap fund are 42 per cent and for Kotak Small Cap fund are 63 per cent to generate CAGR of 10 per cent to 20 per cent in 3-year period. Here, in this case as well, the SBI Small Cap clearly stands out wherein there are 63 per cent chances that it may generate CAGR of more than 30 per cent in 3-year period. The returns space of 10 per cent to 20 per cent is something that even the small-cap indices are expect to generate CAGR in 3-year period.



Looking at the above table, we can say that in a five-year period, the small-cap funds have not generated negative returns. For the overall small cap fund category, 10 per cent to 20 per cent CAGR is the space where maximum funds have probability. Not just funds, but also small-cap indices have shown similar probability. Even in the 5-year rolling return period, SBI Small Cap clearly stands out with around 59 per cent of the chances to get CAGR of 20 per cent to 30 per cent and 37 per cent chances of getting returns above 30 per cent in 5-year period. Though, if you can notice that there are zero per cent chances for any of the funds or even the small-cap indices to generate negative returns. However, as our study period is from November 29, 2013 to June 7, 2019, the number of observations is less in the 5-year rolling return analysis, so it is less reliable. In terms of reliability, it is better to consider 1-year and 3-year rolling returns.

Risks involved while investing in small-cap funds
As stated earlier, risk is something one should not ignore. One should consider risk along with returns while investing. The risk can be measured in terms of beta. If we look at the average beta of the small-cap funds, then it turns out to be 0.75, which is 0.25 points less than the market. Market has a beta of 1. It is presumed that beta above 1 is risky and beta below 1 is less risky than the market. However, this does not mean in any way that the small-cap funds are less risky. They indeed carry a good amount of risk. When the markets are down, small-cap funds would be the one to be hit the most by such market downfall or correction.

Investment duration
When it comes to investment, time horizon can be one of the deciding factors. So, it is very important to understand the time horizon for which you wish to invest. If your investment time horizon is short term or medium term, then staying away from the small-cap funds would be a good idea. However, you can consider investing in small-cap funds if your investment time horizon is long term, and even in the long term, if it is more than 10 years. Small-cap funds can be used as a good source of accumulation for your wealth creation goal, which usually is more than 10 years away. Defining the investment time horizon helps to mitigate risks involved while investing.

Who should invest in small cap funds?
Investors usually get lured by the handsome returns generated by the small-cap funds. However, they do not consider their own risk-taking appetite before investing. Knowing the risk of the product and knowing your own risk bearing capacity are two different things. Risk involved in the product is measured on a quantitative basis, whereas your own risk is derived by considering your psychology. So, it is important for you to first assess your risk profile before investing. This will help you to understand what is your risk-taking ability and which investment products best suit you. A moderately aggressive to aggressive investor can consider investing in small-cap funds if the investment horizon is 10-plus years. However, conservative to moderately conservative risk takers should strictly avoid investing in small-cap funds. But if at all you wish to invest, then it should not be more than 10 per cent of your overall portfolio.

How to select small cap funds?

Returns : While taking returns into consideration when selecting a small-cap fund, then the returns need to be considered over an entire market cycle. One market cycle is typically for 5 years. So, to select the small-cap fund, it must at least have a history of one complete market cycle. Small-cap, of course, gives exceptionally good returns during the bull market phase. However, how it performs during the bear phase actually matters. Even while considering the returns, it is always better to consider rolling returns rather than trailing and absolute returns.

Fund manager : Only quantitative analysis is not enough for the Indian small-cap companies. This is because, with smallcap companies, a negative regulatory environment, bad quarter or lack of proper governance can lead the top performing stock to tank in a blink. So, while selecting small-cap stocks, not just quantitative but also qualitative approach is required. This is why a small-cap fund portfolio needs a seasoned fund manager to manage. While selecting small-cap funds, it is important to check whether the fund manager is in the profession for a decade and is managing the fund for at least five years.

Portfolio turnover : A high turnover ratio in the small-cap space is a big 'no'. Getting wrong investment calls frequently and then winding up such calls can have a good amount of impact cost. Here the fund manager requires to take an investment call carefully and hold the stock with conviction. This would bring down the portfolio turnover ratio of the fund. A turnover ratio of less than 30 per cent is a good sign.

Risk : This is one of the factors that also needs to be considered while investing in small-cap funds. When it comes to risk (which we have taken as 'beta'), it is really important to check whether the fund is taking excessive risk when compared to its peers or benchmark. It is also important to select the right parameters to gauge the risk of the fund. It is also important not just to consider the trailing risk, but assessing how the risk factor of the fund has been when compared to its benchmark and peers in one complete market cycle is important.

Conclusion : Investment in small-cap funds requires a careful study. Also, in this case, consideration of your risk profile matters. Even if your risk profile allows you to invest in these funds, it is really crucial for you to take calculated risk. Investment in small-cap funds demands long term time horizon of 10-plus years. So, to benefit from investing in small-cap funds, you need to remain invested for such longer period. Having a financial plan in place is also important as it would clearly state your current financial situation along with your financial objectives. Based on the same, you would have a clear idea as to where to invest and how much to invest. So, have a financial plan in place if you already do not have one and review it periodically.

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