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Small-Cap Funds:How Good Are They?

Small-Cap Funds:How Good Are They?


While small-cap funds can go through meteoric highs like large-cap and mid-cap funds, what is important is to note what happens when the downward slide begins. How much time do small-cap funds take to recover? And then is it worth the risk to invest in small-cap funds? The article provides the ‘truth and dare’ equation


The global pandemic following the outbreak of the virus in China has led to the rout of not only the frontline indices but also the mid-cap and small-cap indices. Though we have seen a bit of recovery from the recent lows, yet, the fall has been significant. Even currently the markets have been more or less flat with a negative bias. Both broader and frontline indices have seen a negative return over a three-year period. Nevertheless, the broader indices have underperformed the frontline indices. The graph below shows the performance of different indices in the last 10 years.

It clearly shows how the small-cap and mid-cap have underperformed the large-cap indices in a different time period. The worst performers have been the small-cap indices that failed to generate positive returns over five years. Some of you will argue that point to point returns may hide the outperformance in between. Therefore, to understand it better we have also plotted the daily price chart of the indices for the last 10 years.

As can be seen from the above graph, for most of the time over the 10-year period, small-cap indices have underperformed large-cap and mid-cap indices. Therefore this leads us to the prime question about whether at all you need small-cap funds in your portfolio. The mutual funds dedicated to small-cap also follow the small-cap indices in terms of performance. They have also performed in tandem with the index. Small-cap funds are relatively new (the first fund was launched in the year 2005) compared to large-cap and mid-cap funds that can be traced to the nineties. Small-cap funds gained major traction during the market rally of late 2013. Due to the stellar performance of small-cap funds during the 2014 rally, many people started fresh investments through a systematic investment plan (SIP).

In fact, many MF distributors did push small-cap funds to Gen Y earners. Taking into account the high risk appetite of the young and new investors, their advice was that small-cap would do better than the large-cap funds in the longer run and hence made for a sound investment approach. However, the story is quite the opposite. This can be seen in the graph alongside showing the price movement of Sensex, S & P BSE Midcap and S & P BSE Smallcap indices. So, should you invest in small-cap funds? The investment in small-cap funds is like a double-edged sword. They are quite volatile in nature. In a considerably short time, they rise to pretty high levels and then fall with the same pace. Also, they take quite a long time to recover.

Falls and Recoveries
Let us now look at the time it takes for a large-caps, mid-caps and small-caps to recover. Each one of them takes its own time on account of their quintessential traits even though at times we have seen some false recoveries. However, ignoring that aspect, we now look at how much time it has taken for large-cap, mid-cap and small-cap indices to come back to the point from where they started falling. For this we would look at the classic example of the 2008 global financial crises.

☛Net inflows in small-cap funds as on April 2020 stood at Rs384 crores as compared to Rs956 crores in April 2019, a sharp drop of 60 per cent on a yearly basis.

☛AUM of small-cap funds as on April 2020 stood at Rs40,483 crores as compared to Rs43,872 crores in April 2019, declined by 7.73 per cent on a yearly basis.

The above three graphs clearly show how much time it took for large-cap index, mid-cap index and small-cap index to fall and to recover. For S & P BSE Sensex it took 423 days or one year and two months to reach its trough from its peak. But it took 1,032 days or almost three years to recover. Whereas, when we look at the S & P BSE Midcap index, it took almost 430 days or one year and two months to end the fall. But recovery took quite a bit of time. It took 2,074 days or six years to recover. We can, however, see quite a bit of recovery in the initial days from March 2009 to November 2010. But that was again led by a fall from November 2010 to August 2013. Hence, it took more than five years to reach the price from where it started falling in the year 2008.

In the case of S & P BSE Smallcap it took nearly about the same time as S & P BSE Sensex and S & P BSE Midcap index to end the fall (427 days or one year and two months). But when it came to recovery it proved to be a bit slower than even the S & P BSE Midcap index. S & P BSE Smallcap index took around 2,929 days or eight years to recover from the fall even though like S & P BSE Midcap index, even this one saw good recovery in the initial days from March 2009 to November 2010. This was again followed by a fall from November 2010 to September 2013. Therefore, it took quite long time compared to S & P BSE Sensex and S & P BSE Midcap index to reach the price from where it started falling in the year 2008.

As the above table summarises, all three indices took almost the same time to end the fall but it took surprisingly different times to recover. S & P BSE Sensex took the least time to recover. This was followed by S & P BSE Midcap index and S & P BSE Smallcap index. Therefore, the above study shows that small-caps take a similar time to end the fall but it takes thrice the time to recover when compared to large-caps. SIP and Small-Cap Funds
Many of you might argue that one can be better off by engaging in a systematic investment plan (SIP) in small-cap funds as this gives you the benefit of rupee cost averaging. So, to understand whether that’s the case we have calculated the SIP returns of small-cap funds of the past 10 years.

It can be concluded from the above table that apart from two funds, the other funds have given returns less than 8 per cent. In fact, the average SIP returns of the category for the period May 2010 to April 2020 is 7.06 per cent. This clearly shows that even disciplined investing in small-cap funds can lead you to such inferior returns for the risk undertaken. To further understand the performance of small-cap funds let us break this 10-year period into two five-year periods from May 2010 to April 2015 and from May 2015 to April 2020.

It can be seen that in the first five-year period from May 2010 to April 2015, small-cap funds gave spectacular returns. Even the average SIP returns of the small-cap category stood at 26.95 per cent. But now you can see that in the next five-year period, all these returns are lost. Here SIP was not able to reduce the risk.

Thus, only one fund was able to generate positive returns while the rest have given negative returns. This shows that what went up so quick also came down with equal alacrity. Though such a risk is with all equity mutual funds, it certainly is more visible or present in small-cap funds.

Our analysis has shown that small-cap funds are indeed a very risky bet and even investing in them via SIP does not help in reducing the risk. They do not even give you returns for the amount of risk you are undertaking. Hence, if you have certain financial goals, then you can clearly avoid investing in smallcap funds. This will not just help you to achieve your goals with some certainty but also prevent you from taking unnecessary risks. An investor with the goal of wealth creation can consider investing in small-cap funds with active management.

However, conservative investors should stay away from small-cap funds. Even opportunists can invest in small-cap funds at low NAV (as it is now) and sell when they move up. As a thumb rule, consider exiting from small-cap funds when any fund in this category stops accepting lump sum and invest only when they start accepting lump sum. In 2017, most of the small-cap funds stopped accepting lump sum investment though they are now open for doing so.

❝ Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and mutual funds altogether. ❞

- Peter Lynch 

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