Planning to Buy Small Cap Funds in 2020? Here are Some Tips

Do Small Cap Funds Outperform Large Cap Funds?

You really cannot generalize but it has been observed that small cap funds tend to have a better ability to generate above market returns. That is because most of these small cap companies are focused businesses. They operate on low debt, largely because they do not have access to massive debt. This makes their business model more focused.

The second thing you need to check is the size of the small cap fund. Normally, the choice of small cap stocks is limited that is why small cap funds will struggle once their AUM crosses a certain limit. Hence it has been seen that the small cap funds with middle of the road AUMs generally do better.

Do Small Cap Funds Really Outperform Largecaps?

The proof of the pudding lies in the eating and here is an actual sample of small cap funds and the returns they have generated since inception. Small caps have grown in size and today the small cap funds put together have a combined AUM of nearly Rs.99,000 crore. These funds have been ranked based on their performance since inception. As can be seen, the lowest return of a small cap fund since inception is 14.56% on CAGR basis while the maximum returns are above 55%.

Data Source: AMFI

Almost all the small cap funds have done extremely well and have specifically done better than the large cap funds on an average. If you look at the median returns on these small cap funds, it is closer to 25%, which is much higher than what large caps or mid-caps would generate since inception. So the empirical proof is right in front of you.

Do I need to look at the portfolio composition of Small Cap Funds?

That is almost mandatory. Don’t ever select a small cap fund without a detailed look at its portfolio. Every mutual fund scheme provides detailed information on the portfolio composition. You can find this on the official website of the fund house and many of the aggregators like Value Research or Morningstar will also give you detailed notes on the portfolio composition.

There is nothing like a benchmark because a small cap index is too heterogenous to be of any use to you. Diversification is one of the primary goals of investing in small-cap funds and you must focus on schemes that have quality small-cap stocks from different sectors like banking/finance, IT, pharma, automotive, etc. You find more of niche plays in small caps.

How important is Historical Performance in Small Cap Funds?

When it comes to small cap funds, you look at the historical returns for two reasons. You want to check if the fund has delivered in the past and how consistently it has delivered the goods. A large number of investors select mutual funds based on a list of top performers that they find online. But these lists mostly pertain only to the recent performance of the scheme. Experienced investors know that consistency is the key.

Look for consistency in returns across market cycles both on a short-term and long-term basis. For example, if a small cap fund has done well over a 1 year period, 3 year period and 5 year period, it is very unlikely that you can go wrong on these ideas. This kind of a consistency evaluation will enable you select to better select a small cap scheme as compared to only considering recent performance.

Are there some good Financial Ratios I can look at for Small Cap Funds?

Actually, there are quite a few of them and I will quickly run you thorough these ratios and their application. Financial ratios are an integral part of mutual fund evaluation. Some of the most important ratios that you should analyse include as under.

• Sharpe Ratio is the risk-adjusted portfolio returns of a typical small cap fund. Here the excess returns over the risk-free rate are divided by the standard deviation. This gives risk adjusted returns or return per unit of risk. Schemes with higher Sharpe Ratio are considered to have more potential as compared to schemes with a lower Sharpe Ratio.
• Standard Deviation is a more simple and representative measure of risk, not of returns. Standard deviation shows how much of volatility there is the returns of the small cap funds. By default, small cap funds have higher standard deviation than large cap funds but an internal peer group comparison will help you. Funds with a high Standard Deviation are considered to be more volatile and riskier compared to schemes with a lower Standard Deviation.
• Beta is a variant of risk, but unlike standard deviation that considers total risk, the Beta only considers the systematic risk that cannot be diversified away. For instance, if the Beta of a mutual fund scheme is 1, the volatility of the fund and that of the index it tracks is similar. If the Beta is 1.4, the fund is aggressive and is 40% more sensitive to the price movements of the benchmark. Generally, small cap funds tend to be more volatile than the index.
• Treynor Ratio is the risk-adjusted portfolio returns of a typical small cap fund and is a slight variant of the Sharpe ratio. Here the excess returns over the risk-free rate are divided by the Beta instead of the standard deviation. This gives risk adjusted returns or return per unit of systematic risk. Schemes with higher Treynor Ratio are considered to have more potential as compared to schemes with a lower Treynor Ratio.

Does the fund house and Fund Manager matter to Small Cap Funds?

It is always better to select a reputed fund house with an established history of managing small cap funds successfully. Such funds have built the expertise and ecosystem for managing small cap funds. Also look for fund management teams that have been stable over time as this will ensure continuity of investment strategy, which is critical for small cap funds.

A final word on extent of exposure to small cap funds. You must be guided by your financial plan and the asset allocation proposed. Once the equity allocation is done, small cap funds must not exceed 10-15% of that. That is the thumb rule.