1. What are Small cap mutual funds?
The market capitalization of a company is determined by the market value of its outstanding shares. The size of the company is an important criterion when selecting equity portfolios. This is because, depending on the size of the company, the portfolio would have its unique set of opportunities and risks.
2. Who should invest in small-cap mutual funds?
Small cap funds invest predominantly in small companies and small-cap stocks that have the potential for growth. These stock can double or triple in a short span of time of just a few years, but this also implies that the return from these funds is subject to high volatility. Hence, if you want to invest in small cap stocks you would be better off to invest in small cap funds to diversify your portfolio of small cap stocks and minimize the volatility.
As an investor, if you are not averse to taking high or moderate risks, you can consider investing about 15 to 20 percent in small-cap funds for a period of 5 to 10 years.
3. Things an investor should consider when investing in small-cap funds
Small-cap mutual funds are subject to risk and as an investor, you must weigh in the various components that affect the performance of these funds. You should take into consideration your age, your tolerance for risk, the objective of your investment and your investment horizon, etc.
Enlisted are few other things to take into account before investing in these funds.
a. The construction of the portfolio
Pick funds that balance your portfolio. Try investing in funds that have the confidence of holding on like for example it is noted that successful funds tend to have portfolio turnover ratios of about less than 30 percent. It is wise to avoid funds that are more inclined towards the large cap or the top holdings in an inappropriate way.
b. The past performance of the small-cap fund
Note that when deciding, you can’t rely on just the very recent performance of the funds, no matter well it did. You must take into consideration the performance of the fund through both the bullish and the bearish market cycle. Get hold of the past 5 years returns of the fun and compare its performance with other similar funds over the course of the long run. If you find a fund that has been consistent in all market conditions and cycles, it can be considered.
c. Check the P/E Ratio
Looking at the P/E ratio will give you an idea as to how much risk your fund is taking. Small cap funds that have a P/E ratio of above 30x are considered risky. It will also tell you by how much your fund is overpaying for growth.
d. The Choice of a quality fund house
Do your research and pick those fund houses that carry a record of beating benchmark performances in both the high and the low market cycles. The ideal fund house must have an impeccable investment process along with technique to manage risk, an expert research team and good coverage. If you seek further information on the same, reach out to ClearTax and our expert advisors will guide you.
e. Know what your options are
You must decide between risk and reward. Explore options that allow your small-cap fund the flexibility to hold high cash or even invest in the mid and large-cap stock. 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 requires qualitative analysis. The fund manager must also have a strong performance record.
g. The 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 their peers. Seek out options and the potential of garnering good returns from various schemes with low volatility.
4. How to evaluate your small-cap mutual fund?
As an investor, you must look at certain financial ratios to evaluate your 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 its 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 larger 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 rerun of a portfolio. A financial portfolio that has 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 percentages from 0 to 100 percent. If a fund has an R-Square of 100 percent it means that its securities’ movements are explained by the movements in the index. A higher value of R-squared indicates a far more useful beta figure.
A fund is said to be offering a higher risk-adjusted return if it has an R-Square value that is close to 100 percent but its Beta is below 1.
Beta is indicative of a funds sensitivity to the correlated movements of a benchmark. If a benchmark has a Beta of 1.0 it means that is exactly as volatile as the benchmark. If a fund has a Beta of say, 0.70 or less, it means that it is 30 percent less volatile and if it the Beta is 1.30, it shows that the fund is 30 percent more sensitive than the benchmark.
Alpha is a measure of an asset manager’s ability to make a profit when a benchmark is also registering a profit. Alpha can be either less than, equal to or more than 1.0. The higher this number, greater is the ability of the manager to make profits from the movements in the benchmark.
5. Advantages and Disadvantages of small-cap funds
A. Advantages of investing in small-cap funds
Historically small-cap funds have shown to provide exponential growth and return if they pick up the right stocks. Given that these stocks are relatively less scrutinized 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 high risk and highly volatile instruments as compared to ELSS or large cap equity-oriented funds. Considering the risk factor, small-cap funds are not suited for the novice investor but is ideal for a seasoned investor or those that have 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. The timing of buying and selling of these funds plays a crucial role.
6. Ranking of top 10 small-cap mutual funds 2018
Based on small Cap fund performance indicator values, listed below are some of the top equity funds. The rankings done here are for a consolidated list of small-cap equity funds on a 1,3 and 5 years return basis.
|1 year||3 year||
|Aditya Birla Sun Life Small & Midcap Fund||15.19||20.55||28.89|
|Aditya Birla Sun Life Small & Midcap Fund-Direct Plan||16.64||21.75||30.09|
|DSP BlackRock Small Cap Fund-Direct Plan||12.28||18.17||35.20|
|DSP BlackRock Small Cap Fund-Regular Plan||11.85||17.48||34.37|
|Franklin India Smaller Companies Fund||14.56||16.67||31.16|
|HDFC Small Cap Fund-Direct Plan||37.78||23.24||27.11|
|HDFC Small Cap Fund-Regular Plan||36.08||21.71||25.80|
|HSBC Small Cap Equity Fund||23.46||17.87||28.83|
|HSBC Small Cap Equity Fund-Direct Plan||24.40||18.76||29.78|
|L&T Emerging Businesses Fund||28.21||24.93||–|
Note: This is a representative list based on key metrics, dated April 23, 2018. It does not serve as a recommendation of funds, nor does it claim to be the only correct way to rank funds.