Will Small-cap Equity Funds Continue to Generate Stellar Returns in 2022?

January 4, 2022 Mutual Fund

The year 2021 was a year of risk-on trade. In India, equities–particularly smaller companies–remained a popular choice among risk-taking investors amidst a buzzing IPO market and expensive valuations.

Small-caps mutual funds reported net inflows worth Rs 2,780 crore in 2021 with 68.49 lakh folios as of November 2021 compared to 49.80 lakh folios in December 2020. Investors looked up to small-cap mutual funds to accelerate wealth creation over the long term.

Graph 1: Month-on-month inflows into small-cap mutual funds in 2021

(Source: AMFI, PersonalFN Research)  

Small-cap companies, as you may know, are relatively lesser-known or undiscovered companies that hold the potential to generate multi-bagger returns and become the large-cap companies of tomorrow. Are you aware that Bajaj Finance, Titan Company, Britannia Industries, which are among the large-cap names today, were small-cap stocks around a decade ago? Having said that, do not be under an impression that every small-cap stock becomes a large-cap or generates attractive returns. It is noteworthy that, for every high-potential small-cap, there is a long list of stocks that can turn out to be wealth destroyers.

In 2021, small-caps outperformed the bellwether indices significantly. The Nifty 50 Total Return Index (TRI) generated 26% absolute returns in the year gone by, whereas the Nifty SmallCap 250 TRI clocked a stellar 63% absolute return. On a 3-year performance, the Nifty 50 TRI has generated 18.3% CAGR while Nifty SmallCap 250 TRI has yielded 24.2% CAGR. This is despite the underperformance of small-caps between 2018 and 2019.

Identifying potential multi-bagger small-cap stocks and investing directly is a difficult task. To invest in small-caps and to diversify your investment portfolio well, it is sensible to invest in a small-cap fund, wherein the professional fund manager and his research team would do the job of picking high growth-potential quality stocks for you.

How have small-cap mutual funds performed in 2021?

Small-cap mutual funds have generated 63% returns on an average in 2021, thereby performing almost at par with Nifty SmallCap 250 TRI.

While the broader market trend and undercurrents have been supportive for small-caps, the active stock selection of small-cap mutual funds has been able to deliver returns in the year gone by. For instance, small-cap mutual funds have taken a low or limited exposure to financial stocks which have been the laggards in 2021. Instead, they have bet on smaller companies from the outperforming sectors such as IT, healthcare, chemicals, construction, engineering, metals, and FMCG, amongst others. Amidst overheated market conditions, certain small-cap mutual fund schemes that took cash calls or followed defensive strategies, underperformed. Against that, small-cap mutual funds that went aggressive taking active portfolio calls did exceedingly well.

Table 1: Top-5 Small-cap Funds

Data as of December 31, 2021

Note: This table only represents the top-performing small-cap mutual funds based solely on past 1-year returns and is NOT a recommendation. Past returns are not indicative of future returns. Select schemes evaluating long-term performance track record and speak to your investment advisor for further assistance.

Mutual Fund investments are subject to market risks. Read all scheme related documents carefully

(Source: ACE MF, PersonalFN Research)  

Table 2: Bottom-5 Small-cap Funds

Data as of December 31, 2021

Note: Schemes that haven’t yet completed 1-year have been ignored. The table only represents the bottom performing small-cap mutual funds based solely on past 1-year returns and is NOT a recommendation. Past returns are not indicative of future returns. Select schemes evaluating long-term performance track record and speak to your investment advisor for further assistance.

Mutual Fund investments are subject to market risks. Read all scheme related documents carefully

(Source: ACE MF, PersonalFN Research)  

Quant Small Cap Fund has been among the best small-cap funds considering its performance. The fund’s relatively smaller asset base (AUM of Rs 1,271 crore as of November 30, 2021) has offered it flexibility. The aggressive bets taken by the fund on the macro-trends following a combination of a top-down and bottom-up approach and growth style of investing has proved rewarding for its investors.

At a time when other small-cap mutual funds have been shying away from financials, Quant Small Cap Fund’s investments in PSU banks have done remarkably well, thereby enhancing the margin of outperformance. Likewise, the bets on metals, capital goods, and real estate have worked in 2021. Quant Small Cap has not been much hesitant in churning its portfolio frequently.

On the other hand, small-cap mutual fund schemes such as Kotak Small Cap Fund and Canara Robeco Small Cap Fund have demonstrated a perfect blend of defensive and aggressive portfolio strategies. They have raised the cash component in the portfolio during times of uncertainty. At the same time, they have shown the courage to invest in high-beta-economy-facing stocks, including the construction and metal companies.

BOI AXA Small Cap Fund has thrown a big surprise by featuring among the best small-cap mutual fund performers of 2021 in three years since its launch in December 2018. BOI AXA Small Cap Fund has clocked 42.5% compounded annualized returns over 3 years, outperforming its benchmark, the Nifty 50 by a significant margin (of 17.5%). The fund manager has followed a growth style in managing the scheme and rode well on the rally in chemical, technology, and certain financial stocks. Its exposure to financials is broadly restricted to non-lending financial services companies which have been the outperformers in the year gone by.

Speaking about L&T Emerging Businesses Fund, it too has pursued a growth style by investing predominantly in construction, engineering, metals, IT, textiles, and chemical stocks in the small-cap domain. This has helped the scheme to outperform not only the broader markets but most of its small-cap peers as well.

Nippon India Small Cap Fund has followed slightly defensive strategies and diversified its portfolio amply (into mid-sized companies as well), and its intelligent sector calls (Chemicals, IT and consumer durables have remained its favourites) has led the scheme to be an above-average performer.

Amongst the underperforming schemes, SBI Small Cap Fund has taken the aggressive cash calls. The fund held no exposure to IT (at a time when mid and small-cap IT stocks have massively outperformed the broader markets), but it has bet aggressively on consumer durable, FMCG, chemical, construction, metals, and engineering sectors. SBI Small Cap Fund has also preferred defensive small caps and has avoided higher exposure to high-beta economy-facing stocks.

In the case of Aditya Birla SL Small Cap Fund and UTI Small Cap Fund(G), over-diversification dampened the performance of these schemes. As per the portfolio disclosed on November 30, 2021, the highest single-stock exposure of UTI Small Cap Fund has been 2.7%. Barring a few exceptions, the majority of the stocks in the portfolio of Aditya Birla Sun Life Small Cap Fund also had an exposure of under 3%. The sector calls of these funds have not proved to be very rewarding either, especially in the case of UTI Small Cap Fund.

Will small-caps continue to generate attractive returns in 2022 as well?

Well, as you may know, past performance is not an indicator of future returns. Historical data suggests that no particular market cap can be an outperformer every year.

In 2022 due to headwinds or challenges in play, you need to tone down your return expectations. Due to the recent emergence of the Omicron variant with the rise in cases and the US Federal Reserve’s announcement of the reduction of stimulus, the broader markets are expected to remain volatile — it may make the small-caps more vulnerable. If markets go down from the present levels (which is possible), the mid and small-caps would be more vulnerable than large-caps — and you may not yield attractive returns as you did in 2021.

At present, the Price-to-Earnings P/E ratio of Nifty SmallCap 250 stands at 31 times its trail earnings, which is considerably higher than 24 times of Nifty 50. In other words, small caps are more expensive than large caps. Unless the earnings momentum in smaller companies continues, returns expectation from the small-caps is likely to moderate. Note that due to the improvement in earnings in 2021, the base for all four quarters of the calendar year 2022 will be fairly high. Therefore, adopt caution and do not rule out any potential underperformance of small-cap mutual funds.

It would not make sense to add a small-cap fund to accelerate the returns of your mutual fund portfolio unless you have an investment horizon of at least 8 to 10 years and are willing to take a very high risk. Do not just be swayed by returns small-cap mutual funds clocked in 2021 and choose schemes that were the best-performing small-caps of 2021.

What is necessary now is applying the ‘Core & Satellite’ approach to invest in some of the best equity mutual fund schemes out there. This is a time-tested strategy adopted by many successful equity investors across the world that allows you to take advantage of the higher margin of safety and stability offered by large caps and at the same time capitalise on the high growth opportunities of small and midcaps.

The term ‘Core’ applies to the more stable, long-term holdings of the portfolio, whereas the term ‘Satellite’ applies to the strategic portion that would help push up the overall returns of the portfolio across market conditions.

By wisely structuring and timely reviewing the Core and Satellite portions and the holdings therein, you would be able to add stability to the equity mutual fund portfolio while strategically boosting your portfolio returns at the same time.

The ‘Core’ holding should comprise around 65-70% of your equity mutual fund portfolio and consist of a Large-cap Fund, Flexi-cap Fund, and Value Fund/Contra Fund. Whereas the ‘Satellite’ holdings of the portfolio can be around 30%-35%, comprising of a Mid-cap Fund, an Aggressive Hybrid Fund, and maybe a tiny portion in a Small-cap mutual fund (if you have a time horizon of at least 8 to 10 years and the stomach for high risk).

This article first appeared on PersonalFN here