Are Small-Cap Funds Still Lucrative?

While the high growth potential of Small-Cap funds is enticing, the investment comes with a significant downside. Compared to Large-Cap funds, small-caps experience deeper maximum drawdown during market downturns. The article examines the how, why and when of investing in small-cap funds [EasyDNNnews:PaidContentStart]

Small-cap funds on an average have generated return of 54 per cent in the last one year, which remains one of the highest among equity categories. In the last three years, on an annualised basis, it has generated return of 27 per cent, which means that on an absolute basis it has given return of more than 100 per cent. For example, one of the best performing small-cap funds, Quant Small-Cap Fund has generated return of 224 per cent between March 2021 and May 2024. In the same period, Invesco India Small-Cap Fund and HDFC Small-Cap Fund have generated returns of 142 per cent and 148 per cent, respectively. Even among the not-so-good performing funds in recent times, Union Small-Cap Fund has generated return of 119 per cent in the same period. 

Such returns have attracted many investors towards these funds. Since the start of February 2021, investors have poured in a net amount of ₹74,501 crore in small-cap funds. From our study of the last 39 months, it was only in four months when there was a net outflow from small-cap-dedicated funds. Out of these outflows, not a single time was the net outflow more than ₹500 crore. In June 2023, small-cap funds attracted investments of ₹5,471 crore, highest in recent times. 

The gain in small-cap index along with huge inflow has led to a significant increase in the assets under management (AUM) of small-cap funds. This has increased from around ₹67,700 crore in February 2021 to ₹266,109 crore currently, spiralling upward at an annualised rate of more than 50 per cent in the period under consideration. 

Many investors are currently pouring funds into small-cap stocks, driven by the hope that their exceptional performance will persist. Although there was a minor blip in March 2024 following the regulator’s remark about “froth” in the broader market, the subsequent month saw recovery in the small-cap index and returns by small-cap funds. This better return again led to a net inflow of ₹2,208 crore in this category after a minor outflow of ₹94 crore in March 2024. One of the reasons for such a shift among investors following the stress test result was the newfound sense of confidence due to greater transparency and assurances of well-managed funds. 

In April, the folio count was at 19,402,862. What we have observed historically is that excessively investing in any fund category after a period of strong performance is a common mistake among retail investors that often leads to disappointment. Achieving good returns in the small-cap category requires a well-thought-out strategy. Here’s how you can succeed with small-cap funds. 

Getting the Most out of Small-Cap Funds 

Manage Risk
Small cap funds as a category are high beta when compared to the overall market and more volatile when compared to any other category of funds such as large-cap, Mid-Cap or multi-cap category of funds. The graph below shows the average standard deviation of different categories of funds. Up to 28 funds in the small-cap category have shown average standard deviation of 12.72 per cent – the highest among purely cap-wise category. Therefore, while investing in small-cap funds, this risk needs to be understood. 

While the high growth potential of small-cap funds is enticing, it comes with a significant downside. Compared to large-cap funds, small-caps experience deeper maximum drawdown during market downturns. For instance, the Nifty Small-Cap index (a benchmark of small-cap funds) has witnessed a maximum drawdown of 75.98 per cent, considerably higher than the 61 per cent experienced by the large-cap index. This translates to potentially steeper losses for investors in small-cap funds. The graph clearly shows the higher maximum drawdown of the small-cap index compared to the other indices. Therefore, careful consideration of risk tolerance and a long-term investment horizon are crucial before venturing into this asset class. 

Return Expectation
Anyone examining the trailing one-year, three-year and five-year returns on small-cap funds today is likely to be astonished on account of the average returns of 49.3 per cent, 26.5 per cent and 27.7 per cent, respectively. All the figures refer to the compounded annual growth rate (CAGR) for a period greater than one year. In comparison, BSE Sensex or Nifty 50 has delivered nearly half these returns over the same periods. However, such high returns are not typical for small-cap funds; they represent gains from specific points in time—one, three and five years ago from the current date and should not be extrapolated and assumed to be the return going ahead from this category. 

Point-to-point return comparisons are always distorted by the start and end dates for the data. Today, one-year returns on small-cap funds look phenomenal because March 2023 was a recent low point for the small-cap index. From that point, Nifty Small-Cap has shot up by 76 per cent. Nevertheless, if you take a long-term perspective, we see that the one-year returns are much lower. Since the start of April 2005, on an annualised basis, small-cap funds have generated return of 15.42 per cent. 

Importance of Rolling Returns
In such a scenario, carrying out a rolling return analysis is useful to gauge the returns that an average investor is likely to have generated on small-cap funds. A rolling return analysis on daily data for the Nifty Small-Cap 100 index since the start of April 2005 to May 2024 shows that the median return managed by this index over one year is 11.37 per cent. What needs to be observed is the standard deviation of 27 per cent and the maximum and minimum return, which is at 110 per cent and –42.68 per cent. 

When it comes to a three-year period, the situation does not change much. Even on a three-year basis, the annualised return works out to around 11.9 per cent which is close to the mean return. The standard deviation also reduces. Minimum return, however, reduces to 17.37 per cent from 42.68 per cent seen in this one-year period. 

When we extend the analysis for five years, we see that the mean return reduces even though the standard deviation comes down and most importantly, the minimum return is a negative 8.56 per cent. 

The below analysis indicates that extending the investment duration in small-cap funds tends to lower the overall dispersion in returns and reduces the likelihood of incurring significant losses. Although this analysis is based on index performance, individual funds may exhibit different tendencies. Therefore, we will extend our study to include a few small-cap funds to gain further insights. The following table gives you a snapshot of what you can expect in the long run and short run. 

In the short run, such as within a year, your returns from small-cap funds could potentially double, but there’s also the risk of losing more than a quarter of your invested value within the same period. However, as you extend your investment horizon, the likelihood of incurring negative returns decreases. For example, over a five-year period, both HDFC Small-Cap Fund and Invesco India Small-Cap Fund showed minimum returns of 1.56 per cent and 26.04 per cent, respectively. Nevertheless, in the case of a one-year period, the minimum returns of these funds were –43.31 per cent and –25.28 per cent, respectively. 

Investors currently enticed by the past five-year or three-year returns on small-cap funds should recognise that they are witnessing one of the best periods on record for this category. As indicated in the analysis, such stellar returns have been achieved only about 25 per cent of the time. According to the law of averages, after delivering exceptional returns in the past five years, returns on small-cap funds might revert to normal or below normal levels over the next few years. 

Historically, the median five-year return on active small-cap funds has been around 17-20 per cent. This should moderate your long-term return expectations from this category. The above rolling return analysis shows that for investors who held the small-cap index for one-year periods, the probability is that they might have experienced a loss 40 per cent. For those who stretched their holding period to five years, losses cropped up 9 per cent of the time(more on this in below paragraphs). For those who held on for 10 years, losses were a minuscule possibility. 

Distribution of Rolling Returns
Now let’s get a glimpse of distribution of these rolling returns over different periods. The histogram of one-year of rolling returns shows the distribution of returns of large-cap, mid-cap and small-cap funds represented by their Nifty indices. It is clearly visible that Nifty Small-Cap 250 returns are widely distributed and present in both the extremes. 

In the case of a five-year period of rolling returns, the returns are concentrated in the middle between 5-20 per cent. What are the key takeaways from this analysis? 

Key Takeaways
This analysis provides two key takeaways for investors. First, avoid investing money in small-cap funds that you might need to withdraw within the next five years. Over one-year or three-year timeframes, the likelihood of exiting with sub-par returns is high. Second, since the markets rarely provide advance warning of a correction or bear phase, first-time investors should approach this category through SIPs rather than lump sum, especially during the bull markets. 

Roaring bull markets are poor times to make your initial investments in small-cap funds. When the inevitable correction arrives, the tendency to panic and switch out or stop SIPs can be high. To avoid the behavioural mistake of bailing out too soon, it is wise to start your small-cap fund investments after a significant market decline. This approach can help you stay committed to your investments and significantly improve your long-term returns. 

Predicting market tops or bottoms is possible only with the benefit of hindsight. However, to achieve better returns from your small-cap funds, it is sufficient to invest after a significant fall in market indices. First-time investors with no small-cap allocation can start with small SIPs during a bull market and increase their investments after substantial declines. Seasoned investors with an existing small-cap allocation should refrain from adding to it during the bull markets and wait to make additional investments (SIPs or lump sum) until the market falls. 

MF Investment
Investing in mutual funds differs significantly from investing directly in equities, and there are additional factors to consider when entering or exiting mid-cap and small-cap-dedicated equity funds. First of all, these funds are positioned at the higher end of the risk-return spectrum and are not suitable for investors who cannot tolerate significant volatility. These funds are highly volatile and can experience substantial drawdown, quickly moving from highs to lows. For example, in 2008, some mid-cap and small-cap-dedicated funds saw their NAVs drop by more than 70 per cent in a single year. 

Many investors tend to go overboard, adding more than two or three funds from each category. While this approach might seem good for diversification, it is advisable to include no more than two funds from each category in your portfolio to avoid duplication of sectors and stocks. Before adding a new mutual fund scheme, check the top three sectors and the top 10 holdings of the new fund to ensure your existing schemes do not already have similar exposures. 

Research by Morningstar reveals that between March 2011 and February 2021, Indian stocks’ outperformance over cash was concentrated in just eight months—less than 6.7 per cent of the time in the sample. If you held stocks for all the 112 months except those eight critical months when the equity market yielded extraordinary returns, your investment would not have outperformed cash. 

Given that small-cap funds can oscillate between extremely good and terribly bad returns, the size of your small-cap investments and SIPs should be proportionate to your overall equity portfolio. Determine a specific allocation to small-cap funds within your equity portfolio based on your risk appetite (say, 10-25 per cent), and size your lump sum or SIPs accordingly. Avoid the temptation to heavily invest in this category during favourable market conditions.

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