5 Best Small-cap Funds to Buy

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The top-5 Small-cap Funds that have built wealth for investors

Out of 23 Small-cap Funds on offer, 20 have completed three years and only 14 have a track record of at least 5 years.

To find the 5 best Small-cap Funds, we have considered 5 years as an appropriate time horizon given the high-risk involved.

Plus, this period of 5 years is considered as it automatically filters out funds/schemes that haven't seen longer market phases. This could include a prolonged challenging phase for smallcap companies.

If you remember, in the market downturn that began in 2018, the smallcap category got impacted the most.

Table 1: Performance of the 5 best Small-cap Funds across timeframes

We have also considered Standard Deviation (SD), which is a measure of volatility/risk and the Sharp Ratio (SR), a test of risk-adjusted returns.

Ideally, a fund with a lower Standard Deviation and higher Sharpe Ratio tends to compensate investors better than a highly volatile fund having a low Sharpe Ratio.

But again, 'high' and 'low' are relative terms here. Thus comparing the performance of a fund against the category average is necessary.

Table 2: Performance of the 5 Best funds in the bull market phases

When we evaluated the performance of the 5 best funds across market phases, we came across some interesting observations.

The Quant Small Cap Fund has done exceptionally well across market phases. Axis Small Cap Fund and SBI Small Cap Fund have been outperformers during bearish market phases, while Nippon Small Cap Fund and Kotak Small Cap Fund have done well during bull markets.

Table 3: Performance of the 5 best Small-cap Funds in the bear market phases

Let's go deeper and touch upon some more quantitative and qualitative aspects that led to these 5 Small-cap Funds being the best.

Fund #1: Quant Small Cap Fund

Launched in November 1996, the primary investment objective of the Quant Small Cap Fund is to seek to generate capital appreciation and offer long-term growth opportunities by investing in a portfolio of smallcaps.

Contrary to the widely accepted belief that the time spent in the market is more crucial than timing the market, Quant Small Cap Fund isn't averse to frequent portfolio churning. It exposes its investors to very high-risk than its category average but handsomely rewarded its investors on risk-adjusted returns.

Quant Small Cap Fund follows the proprietary VLRT (Valuation, Liquidity, Risk appetite, and Time) framework of the fund house. It uses predictive quantitative indicators to measure the market sentiment and identify investment opportunities while being sector and style agnostic.

The fund hasn't refrained from investing in high beta stocks in sectors such as metals and construction. It hasn't held itself back from taking contra bets on sectors such as media & entertainment and FMCG. Interestingly, Quant Small Cap Fund's largest holding is ITC, comprising 6.8% of its total assets.

Table 4: Top-10 holdings of Quant Small Cap Fund

According to the fund's portfolio as of February 2022, it held 56 stocks with the contribution of top-10 stocks accounting for 39.3% of the portfolio. The cash & cash equivalents comprised around 5.0% of the portfolio to address liquidity needs.

Respectable portfolio characteristics and an astute strategy have led to the superior performance of the fund.

Fund #2: Axis Small Cap Fund

Launched in November 2013, Axis Small Cap Fund aims to generate long-term capital appreciation from a diversified portfolio of predominantly equity and equity-related instruments of small-cap companies.

Axis Small Cap Fund follows the bottom-up approach to stock picking. It focuses on the appreciation potential of individual stocks from a fundamental perspective. It seeks to identify long-term businesses keeping in mind risk and reward by containing mistakes and navigating volatile stock movements.

The fund house believes patience is the key and follows the buy-and-hold strategy when investing in smallcap companies.

Besides, it not only holds larger smallcaps in its portfolio but also takes a meaningful exposure to midcaps and a small portion in largecap companies.

In the absence of opportunities, it prefers to sit in cash (which is currently constitutes around 15% of the total assets) rather than chase the market momentum.

Such an approach is consciously followed from a holistic risk management point of view to manage the risk associated with investing in equity markets.

Table 5: Top 10 holdings of Axis Small Cap Fund

As per the portfolio as of February 2022, Axis Small Cap Fund held 35.6% of its portfolio in top-10 stocks and 20.7% in top-5 sectors by holding 61 stocks in its portfolio.

The fund's exposure to smallcaps, midcaps, and largecaps as of February portfolio was 64.6%, 3.8% and 1.8% respectively.

The Fund has benefited the most from its exposure to Tata Elxsi, Brigade Enterprises, Galaxy Surfactants, Fine Organic Industries, SRF, and CCL Products (India) Ltd in the last few years. This is due to the rally seen in these stocks that form a part of the top-10 holdings.

Moreover, the fund has preferred to stay with popular sectors viz. Chemicals (17.5%), IT (13.3%), construction (9.4%) Healthcare Services (7.6%), and Industrials (7.1%).

Axis Small Cap Fund exposed its investors to reasonable risk compared to its category peers. On a risk-adjusted returns basis, it has outperformed.

Fund #3: SBI Small Cap Fund

Launched in September 2009, the SBI Small Cap Fund has an objective to provide investors with opportunities for long-term growth in the capital by investing predominantly in a well-diversified basket of equity stocks of small-cap companies.

That said, apart from smallcaps, the fund holds some exposure (around 7.9%) to midcaps and 7.4% of its portfolio in cash and equivalent assets.

The fund follows a bottom-up approach to stock-picking and is selective while choosing companies while following a blend of growth and value style of investing.

The fund manager looks to invest in high growth-oriented multi-bagger stocks of small-sized companies but is cautious about the price he is willing to pay for the stock.

Table 6: Top-10 holdings of SBI Small Cap Fund

As per its portfolio as of February 2022, SBI Small Cap Fund held 50 stocks, wherein the top-10 stocks constituted 34.4% of the portfolio.

Currently, the fund has been betting big on consumer goods, industrials, chemicals, and construction among others. It has kept exposure to financial services minimal and avoided IT.

Going by its portfolio characteristics it appears the fund has been betting on a variety of themes like Atmanirbhar Bharat, as well as capex growth in industrials that are expected to play a role in unlocking the growth potential of the economy.

The impeccable performance of the SBI Small Cap Fund has come at a lower level of risk than the category average. Its risk-adjusted returns have been attractive.

Fund #4: Nippon India Small Cap Fund

This fund was launched in September 2010. The primary investment objective of the scheme is to generate long term capital appreciation by investing predominantly in equity and equity-related instruments of small-cap companies.

It's the largest Small-cap Fund with an AUM of Rs 17,775 crore.

Table 7: Top-10 holdings of Nippon India Small Cap Fund

The fund aims to invest in companies having long term growth potential which are available at reasonable valuations.

As per the portfolio as of February 2022, the fund carries an over diversified portfolio of 139 stocks, of which 69.9% is in smallcap, 6.3% is in midcaps, and 8.7% in largecaps. The top-10 holdings formed 22.2% of its total portfolio.

Many of the scheme's portfolio holdings have performed remarkably well in the current bull phase, thus boosting the returns.

Although the fund has exposed its investors to higher risk than its category average, its performance has been quite appealing. It has fared almost in line with the category average on the risk-adjusted returns.

Fund #5: Kotak Small Cap Fund

Launched in February 2005, the investment objective of the scheme is to generate capital appreciation from a diversified portfolio of equity and equity-related securities of small-cap companies.

Kotak Small Cap Fund attempts to spot smallcap companies that are managed by promoter groups with strong integrity.

The fund prefers to invest in companies that have done well across various business cycles, have simple business models, generate free cash flows, and have low leverage. The fund pursues a bottom-up approach and growth style of investing.

Table 8: Top-10 holdings of Kotak Small Cap Fund

As per the portfolio as of February 2022, the fund held a total of 71 stocks, wherein smallcaps comprised 69.4% of the total portfolio, midcaps 11.6%, and largecaps around 2.2%. The top-10 holdings formed 36.1% of its portfolio.

Speaking about its sectoral exposure Consumer Durables (29.3%), Industrials (12.3%), Chemicals (7.4%), Metals (6.3%), and IT (5.6%) were the top-5 sectors.

Many of the underlying stocks of the respective sectors have fared well during the bull market phases and accentuated the fund's return.

The portfolio turnover ratio of 10% suggests that Kotak Small Cap Fund hasn't churned its portfolio often and follows a buy-and-hold strategy.

Who should invest?

If you are an aggressive investor with a stomach for high risk and have a longer investment horizon (5 years or more), you may consider investing in some of the best Small-cap Funds.

Keep in mind, here are a few factors that have a bearing on the performance of Small-cap Funds:

• Asset Under Management (AUM) of the fund
• Marketcap preferences of the fund manager within the universe of smaller companies
• Weightage of the fund to largecap and midcap components if any
• Sectoral and thematic preferences
• Portfolio churning

Many of you might be surprised to see AUM as a crucial factor that affects the return potential. But it decides the portfolio choices a fund manager may make.

If the fund size becomes too large, it could get difficult for the fund manager to manage the scheme and, in turn, weigh down on its performance.

For Instance, Nippon India Small Cap Fund is the largest Small Cap Fund which has an AUM of Rs 17,775 crore as per the portfolio data as of 28 February 2022.

Now while the performance of the fund is satisfactory, the question is, Would the fund manager carry such a long tail of stocks if the fund's AUM was 1/4th of its present size?'

Unlikely!

Typically, it has been seen that fund managers of Small-cap Funds avoid taking exposure of more than 5-6% to a single stock. Depending on the diversification preferences of the fund manager, Small-cap Funds hold 50-70 stocks in their portfolio.

Outlook for Small-cap Funds

Price-to-Earnings (P/E) ratio of the Nifty SmallCap 250 Index currently is 28x, which is higher than the 22x of the Nifty 50 Index. The markets have offered smallcaps a premium in an anticipation of a strong recovery in earnings.

However, on the back of the Ukraine-Russia war, supply-chain disruptions, rising commodity prices and the US Federal Reserve's monetary tightening, the earnings potential of smallcaps will be tested.

Therefore, adopt caution and do not rule out any potential underperformance of small-cap mutual funds.

Unless your risk appetite is very high and you have a time horizon of 5 years or more, you would be better off staying away from Small-cap Funds.

If you are investing in a Small-cap Fund, you need to be ultra-cautious. To mitigate the volatility, consider taking the Systematic Investment Plan (SIP) route while you endeavour to create wealth.

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster.com. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.