• Sun. Dec 3rd, 2023

How to find the best small cap fund to invest in amidst the difference in returns

How to find the best small cap fund to invest in amidst the difference in returns

In the first half of calendar 2023, small-cap funds were the late adopters, accounting for around Rs 18,000 crore of inflows or 25% of new inflows into actively managed equity mutual funds.

Strong inflows are driven by the category’s strong performance compared to other equity mutual fund categories, particularly large and mid-cap funds. The sector returned 34% in the 1 year ending June 23, compared to 23% and 30% for the large and mid-cap sectors respectively.

Even considering a long-term investment horizon of 5 years, the small-cap category has performed well, with returns of 17%, 12% and 15% for the large-cap and mid-cap categories, respectively.

But while the returns are high, investors who are attracted to this segment need to understand that the risks can also be significant. An example is the large variation in the returns of top-performing and underperforming small-cap funds.

In this article, we look at the factors driving the divergence and what investors should look out for when investing in this segment.

Difference between major large and mid cap fund categories in returns of small cap funds

While at the aggregate level, small-cap funds have generated better returns, the variability of returns offers a more nuanced story.

Over a three-year return period, the difference in returns for small cap funds is 31%, 13% for large cap funds, 19% for midcap funds, 10% and 24% for large and mid cap funds. For flexi cap funds.

As can be seen from the chart, the variation is greater when analyzed further for five years.

Source: CRISIL MI&A research; Data as on June 30, 2023
Source: CRISIL MI&A Research; Data as on June 30, 2023

Variability – An outcome of portfolio allocation

Small cap funds should invest at least 65% of their assets in small cap stocks.

According to the list published by the Association of Mutual Funds in India, when companies are classified by market capitalization, except for the top 250 companies in terms of market capitalization, all other companies are classified as small cap. Technically speaking, small cap funds have more than 4,500 stocks to choose from when making an investment decision.

Large cap funds can only invest in the top 100 companies in terms of market capitalization. Hence, the difference in returns between the best and worst funds is less.

Given the large universe, the small-cap fund manager has plenty of choice. Therefore, the securities selected vary widely among each small cap fund.

Examining the portfolio of 24 small cap funds as of May 2023, we find that small cap funds have invested in 438 unique companies as of May 31.

Small-cap fund investments are divided by market cap, with the small-cap exposure within small-cap funds being 100. We found that an average of 94% of the small-cap stocks the funds invested in fell in the top 500 small-cap companies. On average, 72% of the small cap stocks the funds invested in fell among the top 250 small cap companies while 35% were among the top 100 small cap companies.

Source: CRISIL MI&A Research

Similarly, when we look at the overall market cap allocation of small-cap funds, we see that some funds have taken up to 23% exposure to large-cap stocks, while others have kept it at 1%. Similarly, some funds have 29% exposure to midcap stocks, while others maintain midcap exposure at 3%. Their exposure to small cap stocks ranges from 60% to 85%. In short, small cap funds have a diversified portfolio composition in terms of market cap allocation.

Source: CRISIL MI&A Research
Source: CRISIL MI&A Research
Source: CRISIL MI&A Research

Investors should look at portfolio investments and volatility

While small-cap funds offer significant income opportunities, they also carry increased risks. One factor we have analyzed is the variability of returns across schemes due to wide variation in portfolio allocation and use of their investment universe.

Beyond this, investors should note that the volatility of the underlying stocks cannot be ignored. Small cap stocks have a higher level of volatility as compared to large cap stocks. They can experience larger price swings and are more exposed to market fluctuations and investor sentiment.

Also, small-cap stocks often have lower trading volumes and less liquidity compared to large-cap stocks. This higher volatility translates into greater risk and return potential.

Also, a fund manager cannot own more than 10% of the paid-up capital of any company. Given the small market capitalization of these companies, it is difficult for a fund manager to take a meaningful stake in a very small company.

Hence investors should invest in this segment only if they have high risk appetite and long investment horizon. Factors they should consider while selecting funds include consistency of performance, diversification and liquidity of the underlying portfolio.

This column is written by Piyush Gupta, Director of Fund Research, Crisil Market Intelligence and Analytics.

Disclaimer: The views expressed in this article are those of the respective authors. The facts and opinions expressed herein do not necessarily reflect the views of www.financialexpress.com. Consult your financial advisor before investing in mutual funds.

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