small cap mutual funds

A Definitive Guide to Choose the Best Small Cap Funds for Your Portfolio

The small cap mutual funds are enjoying their bit of stardom after delivering spectacular returns in 2020-21. 

The small cap cluster was not explored enough until the SEBI categorised MF schemes and uniformly described them (in 2017). The S&P BSE Smallcap Index showed close to 60% annual returns that year. 

S&P BSE Smallcap Index: Annual Returns
YearReturns (%)
2013-11.23
201469.24
20156.76
20161.77
201759.64
2018-23.41
2019-6.85
202032.11

The MF schemes under this category have enticed investors with their stellar returns in recent times. On average, you can expect 29-31% returns from these schemes. The best small cap mutual funds in 2021 have given over 100% returns in one year.

But there’s a lot more to look at than just the historical returns, especially when it comes to small cap companies.

small cap mutual funds

Source: moneycontrol.com

Understanding Small Cap Stocks

Market capitalisation is a measurement of the value and size of the company listed on the stock exchanges. When you multiply the total number of shares available for trading (outstanding shares) by the latest trading price, you get the market cap of that company.

The top 100 companies with the highest market cap are categorised as large-cap stocks. The next 150 stocks i.e., the 101st to 150th from the list are mid-cap stocks. 

All the remaining stocks are small cap.

The fund manager of a small cap fund has close to 5000 stocks to select from. 

A small cap mutual fund must have at least 65% of the fund’s portfolio allocated to these small cap stocks.

Who Should Invest in Small Cap Mutual Funds?

  • A patient investor with long-term goals
  • Willing to take the high risk
  • Ability to put up with volatility

Guide to Invest in Small Cap Funds

Understand the Fund

The fund manager invests in companies that have the potential to flourish. These companies can turn into multi-baggers and large caps in the future.

For example, over a 10 year period, Eicher Motors and Shree Cement have grown to become a part of large-cap stocks. 

CompanyMarket Cap (₹ Cr.)
20102020
Eicher Motors2,18237,710
Shree Cement7,31166,793

Investing in small cap mutual funds means financing emerging business opportunities.

Having said that, you should understand that the very basic nature of the underlying security of the small cap fund is:

  • small cap stocks are volatile, 
  • riskier, 
  • Have great potential to grow

Match Fund’s Objective to Your Financial Goal

Suppose you need ₹5,00,000 next year to purchase a car. You cannot (and should not) associate this goal with a small cap mutual fund. 

You can’t be dependent on the volatile small cap for funds that you require in the short term.

Investing in the best small cap mutual funds will turn out well for your long-term goals.

The small cap schemes operate with an objective to:

  • Beat the small cap benchmark indices:
  • Generate capital appreciation.
  • Provide long-term growth opportunities.

Fund Size

When choosing among the best small cap mutual funds in 2021 go for medium-sized funds.

Small cap funds have to restrict inflows when they no longer know where to deploy the capital. Unlike large-cap funds, small cap funds cannot increase their investment in small cap companies after a certain limit. 

small cap mutual funds

Source: wealthzi.com

Historical Returns

Warning first! Don’t get persuaded by the historical returns of small cap mutual funds.

While examining the past multiple-year CAGR is essential, it should not be the only variable under the microscope. Unfortunately, investors look only at the past returns and make decisions.

Looking at the present situation, the economies worldwide are still managing to come out of the turbulence caused by the pandemic. Many sectors extremely reacted to this, which was led by investor sentiment and not the performance or value of the stocks the fund holds. The fund’s returns could have been different otherwise.

Along with historical returns, dig in to see what the fund holds, its portfolio distribution.

Comparing 3 to 5 CAGR is enough. The state of the economy 10 years back is completely different today and in the future. Although, investing in small caps should be for a longer duration (like 10 years or more), looking back 10 years is not necessary.

Risk

  • Low liquidity, lack of exit opportunity, 
  • Governance in small cap companies
  • Competition from large players

Fund Manager

You can find all about the fund manager in the scheme information document:

  • Name, age, qualification
  • Past Experience (of at least 10 years)
  • Other schemes managed within the fund house

See how the other schemes are performing. Go through some of the fund manager’s interviews and articles. This will give you an idea about the fund manager’s investment style. Study the fund managers of the best small cap mutual funds and compare them to other fund managers.

When you invest in a fund, you are bestowing the responsibility of managing your investment in the hands of the fund manager.

Go for an experienced fund manager with decades of experience in the industry, one who has been through many different business cycles. He will understand how to tackle small cap companies.

The best small cap mutual funds are perfect wealth-creating opportunities. Small cap companies are often found operating in sectors unreached by large organisations. This allows the investor to invest in growing companies at a lower price.

When investing in a small cap mutual fund, do not invest a lump sum, go for SIP. This way you will be able to average out your investment across various market cycles. If you see the small cap returns over a longer horizon, they are not steep. That’s because these companies take time to grow.

Small cap funds are the best for young investors. However, they should not deploy all their capital towards it. At any stage, it is advised to have no more than 20% exposure in small caps.