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Wish to invest in small cap mutual funds? Read This! - Outside View by PersonalFN

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Wish to invest in small cap mutual funds? Read This!
Nov 21, 2017

"XYZ is a great mutual fund scheme. It has delivered 35% returns in one year"

"It is a 5-star rated fund with supernormal returns over the past year"

These are phrases that are often used by commission-driven distributors to lure gullible investors. Sadly, investors blindly trust the superficial facts, without probing deeper.

Over the past year, small-caps have generated a return in excess of 30%. Mid-caps and multi-cap funds trailed behind with a return of around 25%. Large-caps, known for their steady returns, delivered about 20% over the year.

It is human tendency to trust products that have delivered spectacular past returns.

Several studies in international markets have found sufficient evidence to conclude that retail investors often chase returns. This is why top performing schemes or even top-rated schemes of the past three to five years attract strong investor inflows. Due to this, assets of top performing schemes have more than doubled over the past 12 months.

All it takes is that push distributors give, for investors to confidently put in more money, ignoring the underlying risks.

In the small-cap category, burgeoning fund size fuels a liquidity risk. Small-cap stocks, due to their size, usually have a low trading volume. Due to the risks associated which such stocks; buyers often disappear in an unforeseen event.

In such a situation, the fund manager may end up holding an illiquid stock or may have to sell the stock at a deep discount. At the end of it, your investment in the fund will take a beating.

Certain fund houses have well understood this risk. To deal with it, certain mid-and small-cap schemes have restricted fresh investments. Fund houses such as DSP BlackRock Mutual Fund, Mirae Asset Mutual Fund, and SBI Mutual Fund have restricted inflows into their small-and mid-cap oriented schemes given the high valuations and liquidity risk.

In most cases, lumpsum investments have been disallowed, while allowing investments only through Systematic Investment Plans (SIPs). To deal with the liquidity risk, other schemes are gradually shifting from mid-and small-caps to large-caps.

Volatile Returns of Mid-and Small-cap Mutual Funds
Fund Category 08/Jan/08
Large-cap -53.35 77.97 -24.42 25.97 -20.80 28.08
Multi-cap -55.74 82.08 -25.97 28.98 -18.75 31.92
Mid and Small-cap -62.09 100.86 -28.18 37.63 -16.14 36.41
Data as on November 8, 2017. Returns less than 1-year is absolute, Over 1-year - CAGR.
(Source: ACE MF, PersonalFN Research)

As seen in the table above, mid-and small-cap funds substantially outpaced other categories in a market rally. Unfortunately, when the market tanked, this fund category suffered heavy losses. With an exception when the market corrected between March 2015 and February 2016.

Thus, mid-and small-cap funds have the tendency to go from thrilling highs to dangerous lows. Funds that solely invest in small-cap stocks will incur higher risk. Investors need to be wary of the high volatility.

When considering other category of funds, you will notice that though large-caps are positioned well to deal with the market downside, the upside is limited. Hence, investors can expect stable and decent returns over the long term.

On the other hand, multi-caps, which invest across market-caps, give the best of both worlds - The high-return potential of mid-caps and stability of large-caps. The return generated by the category falls in between large-cap funds and mid-cap funds.

When investing in mutual funds, it is best to diversify your portfolio across market-caps and investment styles.

Hence, though small-cap funds are risky, they should be a part of your portfolio in order to boost long-term returns - provided the funds conform to your risk profile and investment goals.

But, before you invest in small-cap funds, you need to exercise due diligence.

With over a decade of experience in fund research, PersonalFN has outlined important factors you need to look at before adding a small-cap fund to your portfolio.

  1. Past Performance

    Do not rely on the recent performance of a small-cap fund or any mutual fund for that matter. You need to dig deeper and look at the long-term returns generated by the fund. Compare the returns of the fund with its benchmark and other peers across periods and market cycles. If the fund has consistently performed well across all market conditions and time periods, you may shortlist the fund for investment.
  2. Risk-adjusted Returns

    There is no doubt that small-cap funds are risky. However, some funds are capable of managing risk better than other schemes. Hence, you simply should not ignore schemes that generate superior risk adjusted returns. By doing this, you may gain from the potential to generate solid returns with lower volatility when compared to similar schemes.
  3. Portfolio Construction

    You may want to avoid schemes where the exposure is skewed to the top holdings. This concentration adds risk to already risky small-cap fund. Choose funds that maintain an allocation of under-5% to each stock or where the weightage of the top 10 holdings does not exceed 50% of the total portfolio.

    You may also want to avoid funds that have an unproportioned exposure to large-cap stocks. Exposure to large-caps does help in adding stability and improving liquidity of the portfolio, but excessive weightage to large-caps could create a drag on returns when the market is trending up. Consider funds that maintain a proper balance.
  4. Fund Manager Experience

    The experience of the fund manager plays a crucial role in the performance of small-cap funds. Unlike large-cap stocks that are well-researched and offer better corporate governance, small-caps may not always be sincere in their disclosures. It takes the experience of a fund manager to judge management quality and look beyond the numbers being reported. Although at times corporate frauds are well camouflaged, due diligence is necessary. It will be sensible to stay with a fund manager having extensive experience and a dependable performance track record.
  5. Fund House Quality

    Investing in fund houses with multi-national names or those that are well-known in banking or insurance or other fields are not necessarily the best in mutual fund management. You need to pick schemes from a fund house with well-defined investment processes and risk management techniques. You can assess this by exploring how other equity schemes of the fund house have performed. If most of the schemes have generated a benchmark-beating performance across market periods, it is a sign that the fund house has put in place sound investment and risk management strategies. Thus, even if a star fund manager quits, it is likely that the fund may continue its stellar performance as the fund house follows a centralised management process.

An investor needs to prudently select the right mutual fund schemes keeping in mind the above points. This should be combined with factors like age, risk tolerance, investment horizon, investment objective, financial goals, and so on.

It is difficult to predict when the market will favour large-cap or mid-cap, and small-cap stocks. So, as highlighted earlier, it will be prudent to include a mix of different categories of fund strategically in your portfolio.

Given the current high valuations in the small-cap and mid-cap space, these funds may run into high volatility. An investor looking for lesser volatility or relatively stable returns can consider investing in large-cap funds or balanced funds.

If you are unsure about which mutual fund schemes to invest, try PersonalFN's unbiased mutual fund research services. Along with quantitative parameters such as performance, PersonalFN also considers qualitative parameters such as portfolio characteristics, fund manager experience, and fund house quality while analysing mutual fund schemes.

We strongly suggest you subscribe to FundSelect Plus and benefit from the SEVEN time-tested, readymade equity and debt mutual fund portfolios. Based on your risk profile and investment horizon, you can choose out of three equity portfolios (Aggressive, Moderate and Conservative) and three debt portfolios. In addition, you get a readymade tax-saving portfolio as well.

Don't miss out... Subscribe Now!

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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