Looking for Best Small Cap Funds to Invest in 2020?

Looks like small cap stocks will finally see brighter days going forward. In the last one month, the S&P BSE Sensex Smallcap - TRI index gained 10.1% after underperforming its large cap peer for nearly two years. The frontline index S&P BSE Sensex - TRI gained 2.4% during the same period.

This could provide a valuable opportunity to raise exposure in small cap stocks through well-managed small cap funds for your long term goals.

Graph: Are small caps set for rally?

Graph: Are small caps set for rally?
Data as on January 16, 2020
(Source: ACE MF)

What are Small Cap Funds?

Small cap funds are equity-oriented mutual funds mandated to invest at least 65% of its assets in equity and equity related instruments of small cap companies. Small caps are defined as companies ranking beyond 250 in terms of full market capitalisation.

Small caps have high return potential though there are various risks associated with them. These companies have smaller operations with limited access to various resources. At times, if resources are constrained, they may face survival risk in case of economic downturn.

Further, there is liquidity risk associated with them as the limited number of shares makes it difficult for investors to buy and sell as per their wish. That said, a strong business helmed by a well-built management team along with the availability of stock at a reasonable price can make it a very attractive investment.

Graph: Small cap funds are placed higher on risk-return spectrum

Graph: Small cap funds are placed higher on risk-return spectrum
Note: For illustrative purpose only
(Source: PersonalFN Research)

Small-cap funds are placed on the higher end of the risk-return spectrum, just a notch below sector and thematic funds. So, small-cap funds are a very high-risk-high-return investment proposition as the stocks of such companies are highly volatile. When you invest in small-cap funds, make sure you have an investment time horizon of at least 5-7 years, while you endeavour to maximise returns.

If you have a high risk appetite and longer investment horizon, small cap funds can be included in the satellite part of your equity mutual fund portfolio.

Table: Performance of Small cap funds in the last five years

Absolute (%) CAGR (%)
Scheme Name 1 Year 3 Years 5 Years
SBI Small Cap Fund 10.64 15.72 14.99
Axis Small Cap Fund 24.49 16.02 12.70
L&T Emerging Businesses Fund -3.67 9.75 11.57
Nippon India Small Cap Fund 2.31 10.60 11.27
HDFC Small Cap Fund -6.39 11.38 10.41
Kotak Small Cap Fund 12.00 9.26 10.16
DSP Small Cap Fund 6.55 3.41 9.11
Franklin India Smaller Cos Fund -1.63 5.10 8.05
Aditya Birla SL Small Cap Fund -5.56 3.72 7.52
ICICI Pru Smallcap Fund 15.70 7.90 6.92
S&P BSE Small-Cap - TRI -2.26 4.87 5.70
Data as on January 16, 2020
(Source: ACE MF)
*Please note, this table only represents the best performing Small Cap Funds based solely on past returns and is NOT a recommendation. Mutual Fund investments are subject to market risks. Read all scheme related documents carefully. Past performance is not an indicator for future returns. The percentage returns shown are only for an indicative purpose. Speak to your investment advisor for further assistance before investing.

In the last few years, many small cap funds performed poorly as a result of sharp correction in the prices of small cap stocks. Regardless, some schemes managed to outperform the benchmark as well as many of the peers in the small cap funds category across time periods.

Some of the best performing small cap funds during this period according to the unbiased research and analysis at PersonalFN are SBI Small Cap Fund and Axis Small Cap Fund. These funds have rewarded investors in the past with superior risk-adjusted returns through careful stock picking and prudent risk management.

The other decent performers are:

Small cap funds tend to outperform large cap funds and mid cap funds during bull phases, but may suffer heavy losses during bear phases. Therefore, do not invest in small cap funds based only its performance during market rallies. Instead determine how the fund performs during a complete market cycle.

Here are the parameters to look into while selecting best small cap funds:

Quantitative Parameters:

  1. Performance and risk analysis

    Analyse if the fund has shown consistency in performance across various market periods with decent risk-adjusted returns.

    Under this, you need to rank the fund based on quantitative parameters like rolling returns across short-term and long-term periods, such as a 1-year, 3-year, and 5-year timeframe, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

  2. Performance across market cycles

    You need to ensure that the fund has the ability to perform consistently well across multiple market cycles. Therefore, compare the performance of all the available small cap funds vis-a-vis their benchmark index as well as category peers across bull phases and bear market phases.

    A fund that performs well on both sides of the market should rank higher on the list.

Qualitative Parameters

  1. Portfolio Quality

    Adequate Diversification - The scheme should not hold a highly concentrated portfolio. It should have a well-diversified portfolio and the exposure to the top-10 holdings should be ideally under 50%.

    Low Churn - Engaging in high churning can result in higher cost impacting the overall return of the scheme. Therefore, you also need to consider the portfolio turnover ratio and expenses, and penalise funds involved in high churning, i.e. those funds with a turnover ratio of more than 100%.

  2. Quality of Fund Management

    You must consider the fund manager's experience, workload, and the consistency of the fund house. Therefore, assess the following criteria:

    The fund manager's work experience - He/she should have a decent experience in investment research and fund management, ideally over a decade.

    The number of schemes managed - A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is burdened with managing a large number of schemes. If they are managing more than five open-ended funds, it should raise a red flag.

    The efficiency of the fund house in managing your money - Research about the fund house's performance across schemes; find out if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.

    Yes, we know that the above list is a lot for an average investor to look at. It involves number crunching and much of the data is not easily available in one place. But if you do need to narrow down on the top funds, these factors are of utmost importance.

Watch this short video on selecting mutual fund schemes:

Watch this short video on selecting mutual fund schemes

At PersonalFN, we select and recommend mutual funds on quantitative and qualitative parameters using our S.M.A.R.T Score Matrix:

  • S - Systems and Processes

  • M - Market Cycle Performance

  • A - Asset Management Style

  • R - Risk-Reward Ratios

  • T - Performance Track Record

Outlook for small cap funds in 2020

Small cap funds are expected to recover in 2020, (small caps seem to have bottomed out), but the likely gain can come from only few quality names in the segment having strong business fundamentals and quality corporate governance in place. For other stocks in the segment, the pain is likely to continue.

As the economy revives and the liquidity crisis eases on the back of measures taken by the government and RBI, corporate earnings in small caps can improve which would then reflect positively on their stock prices.

However, one cannot expect a sharp economic recovery as the measures undertaken may take time to show results at grass root level. Added to that, rising inflation, geopolitical risks, etc. may heighten volatility in the near term.

So if you are looking to invest in small cap funds in 2020, invest only if you have a long term investment horizon.

Invest in schemes that align with your set investment objective and personalised asset allocation planReview your investment at regular intervals to ensure you're on the right track to accomplish your envisioned financial goals.

Editor's Note:  If you wish to select worthy mutual fund schemes, I recommend you to subscribe to PersonalFN's unbiased premium research service, FundSelect.

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Each fund recommended under FundSelect goes through our stringent process, where they are tested on both quantitative as well as qualitative parameters.

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Author: Divya Grover