Companies having their market capitalisation between Rs 10 crore and Rs 500 crore are classified under ‘small-cap’. This article covers the following:
1. What are Best Small-Cap Mutual Funds?
The size of the company is one of the crucial factors to be considered when structuring your equity portfolio. An equity portfolio’s set of risks and opportunities depends on the size of the company. The best small-cap mutual funds invest predominantly in stocks of small companies that have the potential to grow. These stocks have the potential to double or triple over a very short period, but this also implies that the return from these funds is subject to high volatility.
2. Who Should Invest in Best Small-Cap Mutual Funds?
Small-cap funds are known for their potential to offer high returns. Small-cap funds have a higher probability of outperforming the benchmark when the markets are bullish. However, when the markets enter a slump phase, the NAV of the fund gets affected significantly. If you are ready to take some risk to optimise the returns on your portfolio, then you can choose to invest in small-cap funds. Investing a small portion of your portfolio in small-cap funds for a long-term is an excellent means of generating good returns.
3. Things an Investor Should Consider When Investing in Best Small-Cap Mutual Funds
Small-cap mutual funds are subject to market risk, and investors must weigh in various components that affect the performance of the funds. You need to consider your age, risk tolerance, the objective of your investment, and your investment horizon. Following are some of the other things that you must remember before investing in small-cap funds:
a. Construction of the portfolio
Pick those small-cap mutual funds that balance your portfolio. Consider investing in small-cap funds that invest in small-cap stocks across various sectors. It is wise to avoid funds that predominantly invest in a few stocks. You also look into the frequency of the trading activity going on in the fund. Successful funds tend to have lower portfolio turnover ratios of less than 30%.
b. Past performance of the small-cap fund
Note that when deciding on a particular mutual fund, you can’t rely only on the recent performance, regardless of how well they have performed. You must take into consideration the performance of the fund across the bullish and bearish market cycles. Find out the past five year returns and compare it with peer funds. If a fund has been consistent in all market conditions and periods, then you can go ahead with it.
c. Check the P/E ratio
The P/E ratio will give you an idea about the underlying growth potential of the fund. It will also tell you by how much your fund is overpaying for growth. Small-cap mutual funds having a P/E ratio of above 30x are considered expensive.
d. Choice of a quality fund house
Do your research and pick those fund houses that have a history of beating benchmark performances in both market highs and lows. An ideal fund house should have an impeccable investment process along with the technique of managing risk, an expert research team, and excellent coverage.
e. Know what your options are
You should choose between risk and reward. Explore options that allow your small-cap fund the much-needed flexibility to hold high cash or even invest in the mid- and large-cap stocks. Doing this will no doubt slower the returns on your fund as compared to the returns with the small-cap, but you will get to hold more cash.
f. Get an experienced fund manager
Seek the advice of an experienced and expert fund manager as choosing small-cap funds needs qualitative analysis. The fund manager must also have a strong performance record.
g. Returns must be risk-adjusted
There is no doubt that small-cap funds carry risk, but there are funds that can manage risk better than peers. Explore options and the potential of garnering good returns from various schemes with low volatility.
4. How to Evaluate Your Best Small Cap Mutual Funds?
Investors must look at certain financial ratios to evaluate mutual funds. Some of the important ratios to be considered are as follows:
a. Standard deviation
Standard deviation measures the dispersion of a set of data from the mean or average. In finance, standard deviation denotes the annual rate of return on any investment and also highlights the volatility of the investment. A stock with a higher standard deviation has a more significant price range and indicates higher volatility as compared to a stock with a low standard deviation.
b. Sharpe ratio
This ratio measures the risk-adjusted return of a portfolio. A financial portfolio having a higher Sharpe ratio is seen as a relatively superior portfolio as compared to its peers.
Sharpe Ratio = (Average Fund return – Risk-free Rate)/Standard deviation of the fund returns
R-Square shows the percentage of fund returns that are in line with the benchmark returns. The value of R-Square lies between 0 and 1 and is reflected as a percentage from 0% to 100%. If a fund has an R-Square of 100%, then it means that the movements in the index explain its securities’ movements. A higher value of R-squared indicates a far more useful beta figure.
Example: A fund is said to be offering a higher risk-adjusted return if it has an R-Square value that is close to 100%, but its Beta is below 1.
Beta is indicative of a fund’s sensitivity to the correlated movements of a benchmark. If a fund has a Beta of 1.0, then it means that it is as volatile as the benchmark. If a fund has a Beta of say, 0.70 or less, then it means that it is 30% less volatile than the benchmark and if the Beta is 1.30, then it shows that the fund is 30% more sensitive than the benchmark.
Alpha is a measure of an asset manager’s ability to make profits when a benchmark is also registering a profit. Alpha can be less than, equal to or more than 1.0. Higher the Alpha, more significant is the ability of the manager to make profits from the movements in the benchmark.
5. Advantages and Disadvantages of Best Small-Cap Mutual Funds
a. Advantages of investing in small-cap funds
Historically, the best small-cap mutual funds have provided exponential growth and returns. Given that these stocks are relatively less scrutinised and traded by large investors, there is also a good chance of discovering some undervalued stocks among small-cap companies for small-cap funds.
b. Disadvantages of investing in small-cap funds
Small-cap funds are more risky and volatile when compared to ELSS or large-cap equity-oriented funds. The risk factor makes small-cap funds not suitable for the novice investor but is ideal for a seasoned investor or those having a high-risk appetite. It is also hard to find dividends among small-cap funds because smaller companies tend to reinvest any profits on growing their business, unlike larger companies.
6. Top 10 Best Small-Cap Mutual Funds 2020
Based on small-cap fund performance indicator values, the following are some of the top equity funds. The rankings done here are for a consolidated list of small-cap equity funds based on three years return.
Note: The table does not serve as a recommendation of funds, nor does it claim to be the only correct way to rank funds.