Best Small Cap Mutual Funds - MF Explorer

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Best small cap funds

Small cap mutual funds can help provide kicker returns to an investor’s portfolio and are therefore sought after by aggressive investors. According to SEBI’s Categorisation and Rationalisation of Mutual Funds, small cap funds predominantly invest in small cap stocks. SEBI’s circular mandates that 65% of the total assets of a small cap fund should be invested in equity and equity related instruments of small cap companies. Simply put, a small cap fund would invest at least 65% of its NAV in equity and equity related instrument of small cap companies. The remaining 35% can be invested across other capitalisations – large or mid or in debt instruments etc. Though the returns may seem very attractive, this category of funds comes with its own set of challenges that need to be understood, before deciding if this is the right category for your portfolio. Let’s start by understanding what small cap stocks are.  

What are small cap stocks?

Stocks are categorized on the basis of market capitalisation and in the interest of uniformity, SEBI has defined large, mid and small cap companies as follows:

  • Large cap: 1st to 100th company in terms of full market capitalisation
  • Mid cap: 101st to 250th company in terms of full market capitalisation
  • Small cap: 251st company onwards in terms of full market capitalisation

The key features of small cap companies are:

  • Small caps account for the biggest chunk of listed companies and are obviously smaller than large and mid cap companies.
  • These companies are still in the early stages of growth and not all will be successful. This means that, if selected well, small cap companies have the potential to grow and provide greater returns than large and mid cap stocks, especially during bull markets.
  • But it also means that they can take a beating during economic downturns. Being small and having limited access to resources, these companies are fundamentally more vulnerable and could have a hard time getting back on track.
  • Small cap stocks usually come with a high percentage of promoter holding and therefore, low float or low volume of shares that are traded in the market. This complicates matters in the following ways. One, the share price is very volatile and this gets exacerbated during difficult markets. Two, there may not be enough buyers to purchase the stocks at the prevailing stock price.
  • Small cap stocks are also not as widely researched as their large and mid cap counterparts. While this is a positive on one hand as the upside – if a good company is discovered early – can be huge; the downside can be brutal if enough information is not known about the company and management or governance issues erupt.

Our earlier articles, ‘The big truth about investing in small-cap companies’ and ‘How to (and not to) play the small cap opportunity’ talk about the many pitfalls that could be in store while investing in small caps and being primarily small cap oriented, many of these also get transmitted to small cap funds. This makes it all the more important to pick the right route to gaining exposure to small caps even if it is via a small cap fund.

What is the nature of returns?

Being heavily weighted with small cap stocks, small cap funds bring with them far greater wealth creation ability in the long term than large and mid cap funds. But this journey can be speckled with plenty of volatility in the short and medium term. Small cap funds therefore take a very high risk path to high returns in the long term. In a downturn, even the best small cap funds can take a beating and erode capital in the short to medium term or under perform their benchmark indices.  This risk however, can be managed by selecting the best small cap fund that works toward managing the downside risk without compromising on the returns which is no mean feat.  Here, how the fund makes stock selections in the small cap space (stocks with sound fundamentals, taking cash calls, timely profit booking) and how it invests the 35% that is not mandated to be in small cap equity could have a significant impact on the fund’s risk-return profile. For instance, if this 35% is primarily constituted of large cap stocks, the risk levels of the scheme would come down.

Suitability and how to use

Due to the risk and return profile of small cap funds, they are best suited for the long term (minimum of 5 to 7 years). In the meantime, investors should be prepared to weather ups and downs. Hence, they are ideal for meeting long term goals such as building a retirement corpus or funding children’s education or long term wealth creation. However, the appetite for risk too needs to be very high given the volatility and likely capital erosion that even the best of these funds can see in the short to medium term time frame. 

The best small cap fund could provide an income boost to long term portfolios of high risk investors. Small cap funds along with mid cap funds should form not more than 15% to 30% of a long term portfolio. Small cap funds should not at all be considered for the short or medium term. First time equity investors looking to wet their feet and risk averse investors should steer clear of this category of funds.

What is usually the benchmark index?

The benchmark is an index used to measure the fund’s performance and being actively managed, small cap funds will seek to outperform their chosen benchmark index. You will find that most small cap funds are benchmarked against the Nifty Smallcap 100, Nifty Smallcap 250, S&P BSE Smallcap, S&P BSE 250 Smallcap or the harder to beat total return versions of these indices.

Taxation

Small cap funds are taxed like all other equity mutual funds.

  • IDCW distributions are taxed at the hands of the investor at the applicable tax rate.
  • Short term capital gains (holding period less than 12 months) are taxed at 15%. Long term capital gains (holding period of 12 months or more) above Rs. 1 lakh are taxed at 10%.

How to evaluate small cap funds?

With several small cap funds to choose from, it makes the task of choosing the best small cap fund nothing short of challenging. To complicate matters, many small cap funds restrict inflows as the AUM grows. This is due to challenges on finding opportunities in the small cap space to deploy fund inflows,  limitations on liquidity (lack of sellers when one wants to buy stocks at a specific price / lack of buyers when one wants to sell at specific price levels) and impact costs. The following are the key factors that will have to be borne in mind if you are in the quest to find the best small cap fund. 

  • Consistency of performance and a record of outperforming the benchmark index, peers and category average (though past performance does not guarantee future performance)
  • Risk adjusted returns
  • Ability to contain downside risk
  • Expense ratio
  • An AUM size that allows it to steadily walk the fine line balancing liquidity and impact costs. Our earlier article highlights the drawbacks that could surface with too large an AUM in the small cap fund category such as spotting opportunities to deploy funds and being able to buy or sell at the desired price level even if opportunities had been identified in advance.
  • Fund manager

The best small cap fund

Finding the best small cap fund can be easier said than done. So do take a look at Prime Funds where we have evaluated all the small cap funds and distilled it down to the ones that you could consider, for your long term portfolio if your risk appetite allows you to do so.

 

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