Small cap mutual funds deliver highest return in 5 and 10 years. What should investors do? (2024)

Small cap mutual funds have offered the highest average returns of around 30.62% and 20.45% in the last five and 10 years, an analysis of performance showed.

Around 19 small cap funds have marked their presence in the market. Quant Small Cap Fund offered the highest return of 44.31% in the last five years, followed by Bank of India Small Cap Fund which gave 35.62% return in the same time period. Aditya Birla Sun Life Small Cap Fund gave the lowest return of around 22.15% in the last five years.

In the last 10 years, there were around 13 small cap funds. Nippon India Small Cap Fund, the largest small cap fund based on assets managed, gave the highest return of around 24.91% in the last 10 years. SBI Small Cap Fund gave 24.39% return. Aditya Birla Sun Life Small Cap Fund gave the lowest return of around 16.36% in the last 10 years.

The investment horizon for small cap funds is generally very long, say 5 to 10 years and these funds tend to deliver high returns in the same period. Now the thing is what factors actually helped these funds deliver this stellar performance?

“Earnings of small cap companies have seen a robust growth over the past few years which has been the biggest performance driver for this segment. Historically, we have observed that during periods of higher earnings growth, the valuations also tend to expand and this is the trend that has been witnessed in the small cap segment in the recent past. These two factors along with the sustained retail inflows in small cap funds have resulted in small cap funds delivering such high returns over the past 5 years,” said Nilesh D Naik, Head of Investment Products, Share.Market.

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With a strong catch-up by midcaps and smallcaps in the last couple of months, we still believe the margin of safety (in terms of valuations for these segments at current levels) has reduced as compared to that available in large caps. Keeping this in view, the broader market may see some time correction in certain pockets in the near term and flows will likely shift to Largecaps, according to a report by Axis Securities.

Looking at the current valuations, should an investor choose these funds for investment and what strategy should they follow?

“Investing at a higher valuation level typically reduces the possibility of making outsized returns from a short to medium term perspective. However, given the conducive domestic macroeconomic environment, the earnings outlook for small cap companies continue to remain positive as such businesses typically have more exposure to the domestic economy. Investors need to assess their overall portfolio and ensure that they don’t go overboard on small cap allocation,” suggests Naik.

He also suggests, “Investors who do not have small cap allocation or who are underweight to small cap funds would do well to build such exposure through systematic investing to benefit from potential higher volatility in this segment going forward.”

According to the last stress test results, Nippon India Small Cap Fund will take around 27 days to liquidate its 50% portfolio and 14 days to liquidate 25% of the portfolio. The scheme is the largest fund in the small cap category. Quant Small Cap Fund will take 28 days to liquidate 50% of its portfolio and 14 days to liquidate 25% of the portfolio.

The main purpose of the stress test was to make mid and smallcap investors aware of the risks associated with and the impact of volatility on the portfolio.

The important thing investors want to know is will the stress test results of small cap funds affect the performance of these funds?

“The stress tests are aimed at assessing funds’ ability to meet potential redemption pressure, especially during a stressed market environment. While this has been a recent disclosure requirement mandated by the capital market regulator, it has been a regular practice at many asset management companies to conduct such portfolio stress tests for their internal risk management purpose. As such, this is unlikely to have any direct impact on the performance of small cap funds. However, the disclosures will help in making investors aware of the liquidity risks, especially given the surge in assets managed by such funds at a time when valuations of small cap stocks seem expensive,” comments Naik.

In the last one year, the small cap funds have offered an average return of around 51.93% with the highest return being delivered by Bandhan Small Cap Fund of around 74.29%. Mahindra Manulife Small Cap Fund gave the second highest return of around 70.94% in the last one year. PGIM India Small Cap Fund gave the lowest return of around 34.29% in the similar time frame.

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Will the small cap funds continue to offer such performance going forward? What is the outlook for these funds?

“What we have been witnessing in small cap funds over the past few years is a typical trend in any market upcycle. However, what investors should not forget is that in the short run, sentiments can play an important role in driving stock prices but over the long run what drives stock prices is the earnings growth. Like Benjamin Graham had once said: "In the short run, the market is a voting machine but in the long run, it is a weighing machine." As a category, small cap funds have evolved significantly over the past decade or so given the increasing stock picking opportunity in the space,” commented Nilesh.

He further mentioned that, “In fact about five years back, the largest capitalization stock within the small cap segment used to have a market cap of less than Rs. 9,000 crore. Today even a stock with a market cap of almost Rs. 28,000 crore falls in the small cap segment. More importantly, the number of stocks with a market cap of over Rs. 2,000 crore has increased from about 500 (five years back) to over 1000 stocks now, indicating the increased breadth of the segment. This trend is expected to continue going forward and we can expect small cap funds to play a reasonably important role in the portfolios of investors, especially of those with a higher risk appetite.”

Small cap schemes invest in very small companies or their stocks. That is why investing in small cap stocks is considered extremely risky. The small cap segment can be extremely volatile in the short term, but they have the potential to offer very high returns over a long period. Small cap schemes are recommended only to aggressive investors with a high-risk appetite and long investment horizon, say, around seven to 10 years. ETMutualFunds do not recommend small cap schemes to new and inexperienced investors.

If you are looking for recommendations, see:

Best small cap mutual funds to invest in July 2024

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)