Want To Invest In The Best Small-Cap Funds In 2019? Read This!

The small-cap space, after outperforming from 2013 to 2017 compared to the mid and larger companies, hit turbulence in the year 2018. The S&P BSE Small-Cap - TRI reported a loss of -22.9%, while the S&P BSE Mid-Cap - TRI -12.5% in 2018. The S&P BSE Large Cap - TRI and the S&P BSE Sensex - TRI, on the other hand, posted a gain of +3.7% and +7.2%, respectively in 2018.

Chart 1: Small-caps were hammered last year. Should you invest?

Data as on February 1, 2019 (Base: Rs 10,000)
(Source: ACE MF)

Well, before you take a decision to invest in small-caps--even through small-cap mutual funds-- do note that they aren't for the faint-hearted.

As per the capital market regulator, SEBI, small-cap companies are defined as those that fall beyond the 250th stock in terms of full market capitalization.

A noteworthy trait about small-cap companies is, usually, due to their low trading volume, the investment risk associated with them is higher than with larger firms. Plus, there is an inherent risk involved due to their limited scale of operations, product lines, narrow distribution channels, limited financial and managerial resources, and greater sensitivity to dynamic economic conditions.

Any adverse economic conditions or any policy changes from the government of greater magnitude can have an undesirable impact on the business of small-cap companies, and in turn on their bottom-line. On the other hand, when the economy is booming and business is on an upswing, small-cap companies do quite well, in terms of revenue growth and profits, and sometimes even outpace the larger companies by a noteworthy margin.

Hence, small-cap mutual fund schemes that invest a minimum 65% of its total assets in equity & equity related instruments of small cap companies (i.e. companies that are 251st onwards on a market capitalisation basis) have the tendency to go from thrilling highs to dangerous lows.

Chart 2: How are small-cap funds placed on the risk-return spectrum?

(Note: For illustrative purpose only)

Small-cap funds are placed on the higher end of the risk-return spectrum, just a notch below sector and thematic funds. Therefore, as an investor, you need to be wary of high volatility and have the appetite for very high risk.

Moreover, in the pursuit to clock higher returns, your investment time horizon needs to be at least 7-10 years.

How are valuations in the small-cap space?

The S&P BSE SmallCap Index is trading at a negative P/E of 109.31 as on February 4, 2019. A negative PE indicates that many constituents of the BSE SmallCap index are making losses thereby contributing negatively. Only a handful of small-cap companies are able to manage financial stress, and those who pile up massive debt, rarely are able to manage it when the going gets tough.

The year 2019 is not going to be easy; it could test the patience of several investors. Therefore don't expect a recovery in the small-cap space immediately; even though have been hammered down. Expecting handsome returns in a year may lead to disappointment.

Having said that, if you invest in well-managed small-cap funds that pick fundamentally robust companies at reasonable valuations (and have the potential of being tomorrow's large caps), over the long-term (7-10 years) small-cap funds can generate handsome returns for you. But make sure you have the stomach to assume very-high-risk.

Which are the best small-cap funds for 2019?

(Image source: pixabay.com)

To know potentially the best small-cap fund for 2019, let us look at the top-performing ones in 2018...

Table 1: Best performing small-cap funds of 2018. Should you invest?

Scheme Names Absolute Returns (%) CAGR (%)
 29/Dec/17 To 31/Dec/18   2 Years   3 Years   5 Years 
 IDBI Small Cap Fund -12.6 
 L&T Emerging Businesses Fund -12.9  12.0  18.1 
 Union Small Cap Fund -19.7  1.7  5.2 
 SBI Small Cap Fund -18.6  13.9  16.2  30.4 
 Reliance Small Cap Fund -15.7  10.6  15.7  27.7 
 DSP Small Cap Fund -25.1  -1.4  8.9  24.6 
 Franklin India Smaller Cos Fund -16.4  4.8  12.0  23.9 
 Axis Small Cap Fund -7.9  9.0  11.6  22.8 
 HDFC Small Cap Fund -6.7  18.1  19.6  21.9 
 Sundaram Small Cap Fund -28.6  -1.3  5.6  21.6 
 Kotak Small Cap Fund -16.3  4.0  11.5  21.1 
 Aditya Birla SL Small Cap Fund      -21.7  2.9  11.5  20.8 
 HSBC Small Cap Equity Fund -24.7  1.5  8.8  19.8 
 ICICI Pru Smallcap Fund -21.8  0.5  7.0  12.7 
 Quant Small Cap Fund 3.1  0.8  3.8  6.4 
 Category Average -16.4  5.5  11.1  21.1 
 Category: Benchmark
 Nifty Smallcap 250 – TRI -26.1  0.5  7.5  17.6 
 S&P BSE Small-Cap – TRI -22.9  3.8  9.4  18.4 
Data as on February 1, 2019
(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.

Observing the performance of small-cap funds in 2018, perhaps you would take aback (and rightly so). However, if you evaluate the returns over a longer period, say 5 years, the return clocked by some schemes are very appealing.

Which are the worthy small-cap schemes?

Franklin India Smaller Companies Fund and HDFC Small Cap Fund, in particular, have delivered a superior and consistent performance on both quantitative as well as qualitative parameters. They have adequately compensated their investors for the risk taken.

In addition to that, the following small-cap mutual fund schemes are decent performers:

Axis Small Cap Fund

Aditya Birla SL Small Cap Fund

L&T Emerging Businesses Fund

SBI Small Cap Fund

Reliance Small Cap Fund

All the above small-cap schemes have fared well over longer time frames and across market cycles, outperforming the category average return and their benchmark.

So, if you want to invest in small-cap funds in 2019 hoping to earn attractive returns, invest in well-managed schemes coming from process-driven fund houses and stay invested for the long-term (with an investment time horizon of at least 7-10 years).

Most investors, especially the novice, make a mistake of selecting small-cap funds based on their recent performance. They completely ignore the important factors.

Remember not to pick small-cap funds by:

Remembering investing is a serious and an individualistic exercise. Hence, do not try to ape anyone else's investment portfolio. One man's meat is another man's poison. Each one's risk profile, investment objective, financial goals, and time horizon to accomplish the envisioned financial goals are different.

Unless you have a very high-risk appetite, avoid going gung-ho while investing in small-cap oriented mutual funds; but don't ignore them totally- assess your risk appetite.

Here's how you should go about selecting the best small-cap funds...

Quantitative Parameters:

  1. Performance and risk analysis

    This is to 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 small-cap fund has the ability to perform consistently across multiple market cycles. Therefore, compare the performance of all the available small-cap funds vis-a-vis their benchmark index across bull phases and bear market phases.

    If a fund has consistently generated superior returns-across time frames and market cycles (bull and bear)-and adequately compensated on the risk-return basis, shortlist such a fund.

Qualitative Parameters:

  1. Portfolio Characteristics:

    It is essential for a small-cap fund to hold a portfolio of quality small-cap companies recognising their fundamentals. Furthermore, it is important to pay attention to the following:

    Adequate Diversification - The scheme should not hold a highly concentrated portfolio of select stocks. The portfolio should be well-diversified and the exposure to the top-10 holdings should be ideally under 50%. Evaluating this reduces the risk that comes along with a concentrated portfolio.

    Low Churn - Engaging in high churning can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio, expense ratio, and penalise funds involving a very-high churning.

  2. Quality of Fund Management

    You also need to consider the fund manager's experience, his workload, and the consistency of the fund house. Therefore, assess the following:

    The fund manager's work experience - When picking small-cap companies, the experience of the fund manager plays a vital role. He/she should have sufficient experience in investment research and fund management, ideally over a decade, particularly in the small and mid-cap space.

    It would be sensible to invest/hold a small-cap fund that is managed by a fund manager who has extensive experience and a dependable performance track record.

    The number of schemes managed - A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with a large number of schemes. If he is 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 consistent performance across schemes. Find out if only a few selected schemes are doing well, or most of them. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.

Yes, I know the above evaluation process is quite a lot for an average investor and involves a great deal of number crunching. Nonetheless, if you wish to own the best mutual fund schemes in your portfolio, the aforementioned parameters cannot be ignored.

Watch this short video on selecting mutual fund schemes:


PersonalFN adopts a comprehensive mutual fund research methodology to select the best mutual  funds. Based on a composite score, which has a weightage to each parameter, PersonalFN provides its views on each fund recommended under various mutual fund research services.

The outlook for 2019:

Given that we are heading for Lok Sabha elections in April-May, the year 2019 will be a year of high drama and high (market) volatility.

In the interim Budget 2019, current Finance Minister, Mr Piyush Goyal, nattily highlighted the achievements of the government in the last four-and-a-half years. He emphasised on the agrarian sector, housing sector, tax reforms, the provision of social security for workers in the unorganised sector, among many other things; all of which are expected to provide an impetus to India's consumption theme and rural economy. Plus, a vision for the next decade is articulated in the budget speech. This, in my view, would bode well for the Indian equity market.

The corrected valuations in the small-cap space will provide fund managers with the opportunity to do value picking. However, adequate safeguards for controlling risks in the portfolio construction process need to be adopted by fund managers of small-cap funds whereby the return potential of a small-cap fund is not diluted.

Some of the key influencers for Indian equities include GDP growth (which seems to have lost momentum of late), India Inc.'s earnings growth, how international crude oil prices move, the inflation trajectory, the outcome of Lok Sabha elections, impact of farm loan waiver and increased MSP (Minimum Support Price) on fiscal deficit, and the global macroeconomic and geopolitical backdrop.

The year 2019 will not be an easy year; volatility will be inevitable in the path to wealth creation. To mitigate the risk involved, I suggest opting for the Systematic Investment Plan (SIP), a mode of investing in mutual funds. SIP will facilitate rupee-cost averaging while you endeavour to compound wealth. And finally, choose Direct Plan over a Regular Plan to invest.

Happy Investing!

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Author: Rounaq Neroy