What are Small Cap Mutual Funds?

In the past, large cap, mid cap and small cap stocks were classified based on market cap. Normally, the companies with market cap of less than Rs.5,000 crore are classified as small cap stocks. However, subsequently, SEBI has changed this definition for the purpose of mutual funds. Now small cap is defined based on ranking as under.

• The top 100 stocks ranked on market cap are classified as large cap stocks
• The next 101 to 250 ranked stocks on market cap are mid cap stocks
• Finally, stocks ranked from 251 and below are the small cap stocks.

A mid cap fund is one that invests at least 65% of its corpus in the third category of small cap stocks as defined by SEBI above.

There is no such rule but it has been observed that over time, the small cap funds tend to outperform the large cap funds for a variety of reasons. Here are a few of them.

• Small cap funds gain from some of the advantages of small cap stocks over large cap stocks. For example, small cap funds tend to do better when the interest rates are low and oil prices are falling.
• Small cap funds consist of stocks that are not too diversified. They operate in sectors that are focused either because that is their bandwidth or because they do not have the funds to diversify. This focus helps them perform.
• Thirdly, small cap funds consist of stocks that are rarely overleveraged. Large cap stocks in sectors like power, telecom, infrastructure and metals tend to leverage due to high gestation projects. Small cap stocks are in less capital intensive areas.
• Lastly, smaller stocks have been quicker to adapt and adjust while larger companies take time. As a result, the superior performance of small cap stocks has percolated into the performance of dedicated small cap funds too.

However, it needs to be understood that investing in mid-cap funds is a slightly different ball game compared to large cap funds as they do not offer the benefit of diversification. Here is a checklist of 7 important points that you need to understand and remember before investing in these mid-cap and small cap funds…

There is no hard and fast checklist to invest in small cap funds. However, here are some ground rules that investors in small cap funds can effectively use.

1. Focus on the track record of performance over last 4-5 years. Here we are talking about consistent performance of small cap funds. Why do we suggest this metrics? Unlike large cap stocks, small caps are very heterogeneous. Therefore, they are less vulnerable to economic cycles. Small cap fund managers typically use bottom-up stock selection for such stocks. Hence, consistent performance for a sustained period of 4-5 years is a fairly strong indication of solid stock selection skills of the small cap manager.

2. When you invest in small cap funds, make the risk worth it. That means, look for excess returns well above the Nifty and Sensex returns. In other words, look for alpha. Ideally, ensure that once good small cap funds are selected, your overall exposure to mid-cap funds and small cap funds must not exceed 25% of your equity fund exposure overall.

3. Before selecting a small cap fund, focus on the liquidity score of the fund. Let us just spend a moment on this liquidity score. CRISIL calculates Liquidity score for large cap, mid cap and small cap funds. Liquidity ratio represents the number of days it will take for the fund manager to wind down the entire portfolio without negatively impacting prices. While large cap fund have liquidity ratio of around 1.3 days, mid cap funds have liquidity ratio of 9-11 days and for small cap funds it is normally 25 days. The lower the liquidity ratio, it is better. You feel this pinch if there is a run for redemptions.

4. Given a choice, always prefer a small cap fund where the core management team has been relatively stable. Vote for stability of teams. Investing in small-cap stocks is an art that is perfected by fund managers over a period of time. Hence consistency of the fund management team alone can ensure such performance consistency. Constant churn in people is not good news for small cap funds.

5. When it comes to small cap funds, what really matters is how they perform in bear markets or when markets are in a downturn. That is what tests the character of these small cap funds. Normally, small cap funds outperform in a good market so every fund manager may look smart. In a downturn, the good small cap fund managers stand out. In a downturn, two skills are critical viz. how you select stocks and how you manage risk. If a fund manager can handle these two things in bad times, it is worth investing in that fund.

6. Lastly, availability is a key issue, which is why you find small cap funds stopping accepting fresh flows after a certain point. There is a limit to the quantum of quality small-cap stocks available in the market. Just keep that in mind while making your small cap fund allocation.

You must not lose perspective of small cap fund exposure. When you allocate monies across large cap, mid cap and small cap funds, the ideal mix should be around 70:20:10 for large cap funds, mid cap funds and small cap funds. This will ensure you have the benefit of diversification with power of alpha from mid-cap and small cap funds.

Since small cap funds are very heterogenous, the only way to take call on the fund is to drill deep into the portfolio of these small cap funds. Be cautious if too many stocks in the portfolio are speculative in nature. There are a number of solid small cap companies with promise and you need a small cap fund that invests in good stories.

Debt is bad for all types of stocks if you go beyond a point. However, in the case of small cap stocks, there is a unique problem. Most small cap stocks are focused on a single line of business or are dependent on a small set of customers. Hence higher financial risk of debt can be dangerous for such companies. Be wary of any small cap stock that has a high debt/equity ratio or where the capital base is too large.

Past returns may not be indicative of the future, but they are a good enough indicator to give you an idea about the quality of the small cap fund and its portfolio. Don’t just look at higher past returns but focus more on consistency of returns. If a small cap fund has done well for 8 quarters on a rolling 3 year basis you can bet it will do well in the future too. This is one of the best tests of small cap funds.