Is It the Right Time to Invest in Smallcap Mutual Funds Now?

April 14, 2023 Mutual Fund

If you are a high-risk taker wanting to multiply wealth at a greater pace, then Smallcap Mutual Funds may be an appropriate fit in your portfolio. Small-cap funds are equity-oriented mutual funds mandated to invest at least 65% of their assets in equity and equity-related instruments of small-cap companies.

But the question is whether it is an opportune time to invest in Smallcap Mutual Funds.

After a meaningful correction since the peak of October 2022, the valuation premium for Indian equities has reduced among emerging markets. The 12-month forward Price-to-Equity (P/E) ratio of the Morgan Stanley Capital International (MSCI) India Index is around 19x as against its historical peak.

Even India’s market capitalisation-to-GDP ratio, famously called the Buffett indicator (named after legendary investor Warren Buffett), is below 100 — to be precise at 88% (as of 10th April 2023) — compared to 112% in FY22 — making Indian equities fairly valued.

Graph 1: The P/E ratio of the Nifty Smallcap 250 Index is down from its COVID-19 peak

Data as of 10th April 2023
(Source: data from NSE, PersonalFN Research) 

As regards the trailing P/E of the Nifty Smallcap 250 index, it is currently at around 17x — down from the COVID-19 peak — while the MSCI India Small Cap index 12-month forward P/E is around 19x, also down from the historical peak. Therefore, there appears to be a decent margin of safety.

Having said that, you ought to approach Smallcap Mutual Funds carefully considering a host of quantitative and qualitative parameters for it to be a rewarding experience, and not merely go by past returns as they are in no way indicative of future returns.

An S&P Indices Versus Active Funds (SPIVA) study brings to light that while the S&P BSE 400 MidSmallCap Index (designed to track the performance of the 400 companies within the S&P BSE 500 that are not part of S&P BSE 100), rose 2.2% in the year 2022, 54.9% of active fund managers handling mid and smallcap funds underperformed the index during that period. Now, of course, 2022 was a challenging year for Indian equities, particularly for smallcaps. But even over a longer time frame of 3 years, 5 years, and 10 years, certain schemes have underperformed the benchmark index.

Graph 2: Percent of underperforming Indian Active Funds

(Source: Latest SPIVA India Scorecard) 

Having said that, the mid & smallcaps funds by far have fared the best over the long term. Over the last 10 years, the Nifty Mid 150 -TRI and the Nifty Smallcap 250 – TRI have clocked a CARG of 18.5% and 16.2% respectively (as of 10th April 2023) and outperformed the largecap indices.

Table 1: Performance of Smallcap Indices

(Source: ACE MF, PersonalFN Research) 

If you keep a long-term view while taking exposure to smaller companies, it alleviates the downside risk if the broader markets correct in the near term, and potentially could prove rewarding (on a risk-adjusted basis) provided such companies report pleasing earnings and grab the attention of investors.

How is the performance of Smallcap Mutual Funds?

Some schemes, such as the Quant Small Cap Fund, Nippon India Small Cap Fund, Canara Robeco Small Cap Fund, HSBC Small Cap Fund, Kotak Small Cap Fund, HDFC Small Cap Fund, ICICI Pru Smallcap Fund, and DSP Small Cap Fund among a few others have clocked handsome compounded annualised returns over the last 3 years and 5 years, managed to generate alpha, i.e. outperform the benchmark indices over longer periods, and rewarded investors well on a risk-adjusted basis.

Table 2: Report Card of Smallcap Mutual Funds

(Data as of 10th April 2023)
The category average returns for both solution-oriented and various sub-categories of diversified equity mutual funds are shown for the Direct Plan-Growth option. Returns considered are point-to-point.
Returns over 1 year are compounded annualised; else absolute.
Standard Deviation indicates Total Risk, while Sharpe and Sortino Ratios measure the Risk-Adjusted Return. They are calculated over a 3-Yr period assuming a risk-free rate of 6% p.a.
Past performance is not an indicator of future returns.
The table above is NOT a recommendation as such. Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, PersonalFN Research) 

But among these, the three best Smallcap Mutual Funds to invest in 2023 are Quant Smallcap Fund, Nippon India Small Cap Fund, and Kotak Small Cap Fund due to their appealing long-term performance track record.

Best Smallcap Mutual Fund #1 Quant Small Cap Fund.

Incepted in January 2013 Quant Small Cap Fund is a small-sized scheme in the Smallcap Mutual Fund category with an AUM of Rs 3,579 crore as of 31st March 2023. It follows a quantitative approach to select high-growth potential stocks based on the relevant market, industry, sector and economic parameters. This quantitative approach is based on the fund house’s proprietary VLRT framework, viz. Valuations, Liquidity, Risk, and Timing. Its stock-picking exercise constantly hunts for attractive opportunities across sectors and follows a very active growth-oriented fund management style. Thus, the portfolio turnover ratio of Quant Small Cap Fund is on the higher side compared to its peers.

Quant Small Cap Fund is currently holding 96.4% of its assets in equities (predominantly smallcaps, followed by largecap and midcaps) and the remaining is cash and cash equivalents. It has exposure to companies such as Reliance Industries, ITC, HDFC Bank, RBL Bank, Jindal Stainless, IRB Infrastructure Developers, Punjab National Bank, Bikaji Foods International, Usha Martin, and Just Dial among others, aiming to capitalise on the growth opportunities.

Click here to read our detailed coverage of the features and performance of Quant Small Cap Fund.

Best Smallcap Mutual Fund #2 Nippon India Small Cap Fund

Incepted in September 2010, the Nippon India Small Cap Fund is a large-sized smallcap mutual fund with an AUM of Rs 24,491 crore as of 31st March 2023. The fund uses diversification as a risk-mitigation technique and holds a large portfolio of over 165 stocks (spread across sectors). Currently, the top-10 stocks are comprising only 17.2% of the total equity portfolio.

Nippon India Small Cap Fund aims to identify small-sized high-growth companies with reasonable size, quality management, and rational valuation. These stocks could be from a cross-section of the growth areas of the economy. Currently, the fund is holding 65.6% of its equity assets in smallcaps, 18.6% in midcaps, 11.5% in largecap, and the remaining in debt instruments and cash. It has exposure to companies such as Tube Investments of India, KPIT Technologies, HDFC Bank, Bank of Baroda, Zydus Wellness, Balrampur Chini Mills, NIIT, Larsen & Toubro, Navin Fluorine International, and Tejas Networks, among others. Nippon India Small Cap Fund has held the portfolio with conviction (as reflected by its low portfolio turnover ratio of 23-29% in the last one year) and has been able to generate alpha and outpace many of its peers.

Click here to read our detailed coverage of the features and performance of the Nippon India Small Cap Fund.

Best Smallcap Mutual Fund #3 Kotak Small Cap Fund

Launched in February 2005 as a midcap fund, after SEBI’s mutual fund categorisation and rationalisation norms was classified as a Smallcap Mutual Fund and currently has an AUM of Rs 8,672 crore. Kotak Small Cap Fund follows a growth style aiming to invest predominantly (at least 65%) in smallcap stocks and holds a well-diversified portfolio (of currently 78 stocks).

For its portfolio, it looks to invest in companies that have the following characteristics:

• Proven products and services,
• Record of above-average earnings growth and have the potential to sustain such growth,
• Stock prices that appear to undervalue their growth prospects, and
• Companies that are in their early and more dynamic stage of the life cycle, but are no more considered new or emerging.

As long as the companies fall in the aforementioned criteria, Kotak Small Cap Fund also invests in Initial Public Offerings (IPOs). Currently, as per its March 2023 portfolio, it holds 95.9% of its assets in equities and the rest 4.9% in cash and cash equivalents. Smallcap comprise 67.1% of the equity portfolio, midcaps 23.8% and largecaps 4.7%. Top-10 stocks constitute 31.4% and include names such as Carborundum Universal, Ratnamani Metals & Tubes, Cyient, Century Plyboards (India), Blue Star, Galaxy Surfactants, Supreme Industries, Persistent Systems, Sheela Foam, Garware Technical Fibres and others. Moreover, the fund has followed a buy-and-hold investment strategy to benefit from the long-term growth potential of small-sized companies. And by timely identifying and capturing the available opportunities in the smallcap space, Kotak Small Cap Fund has created significant wealth for its investors over the long term.

If you want to know some more Best Smallcap Mutual Fund schemes to invest in 2023, click here.

How to Invest in Smallcap Mutual Funds?

Smallcap Mutual Funds carry very high risk. Hence, they should be a small portion of your ‘Satellite’ portfolio and the time horizon should at least be 5 years. The term ‘Satellite’ applies to the strategic portion that would help push up the overall returns of the portfolio across market conditions. Whereas the ‘Core’ portfolio, should comprise of more stable and long-term holdings.

Ideally, around 65-70% of your equity mutual fund portfolio should be the ‘Core’ holdings comprising a Largecap Fund, a Flexi-cap Fund, and a Value Fund/Contra Fund. And only around 30-35% should be the ‘Satellite’ holdings comprising of a Midcap Fund, a Large & Mid-cap Fund, an Aggressive Hybrid Fund, and a Smallcap Fund.

When you construct a Core & Satellite portfolio of equity mutual funds, make sure you do not end up over-diversifying the portfolio. Select no more than 7 to 8 best equity schemes. By wisely structuring and timely reviewing the Core and Satellite portions, you would be able to add stability to the portfolio. It would boost your portfolio returns and prove to be a wealth multiplier in the long run. You see, some of the most successful equity investors also usually follow a ‘Core & Satellite’ investment approach.

At present, given that the Indian equity markets are rather volatile on account of a variety of factors in play, it would be prudent to take the Systematic Investment Plan (SIP) route to invest in smallcap Mutual Fund schemes and other types of equity mutual funds while following the Core & Satellite investment approach. If the Indian equity markets correct and/or turn volatile, the inherent rupee-cost averaging feature of SIPs will help mitigate the volatility, and if the market ascends you will be buying a lesser number of units yet continue to grow wealth.

Watch this video on the 5 benefits of starting a SIP.

By investing regularly and systematically via the SIP mode, the risk is mitigated by you focusing on ‘time in the market’ to generate wealth, rather than the time in the market, which could prove hazardous to your wealth and health. To enhance your returns, consider opting for the Direct plan option of mutual funds as they carry a lower expense ratio than a regular plan. Be a thoughtful investor!

This article first appeared on PersonalFN here