What are Small Cap Funds? Basics, Benefits & Returns

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Small Cap Funds

Small cap funds notoriously have a reputation of being a high-risk fund in the equity segment. Even then, we invest in these funds as they have the potential to reward the aggressive risk-takers and the ones patiently invested in it in the long run. This is because the small cap funds tap into the untapped segments and take bets on small companies,  which have very high growth potential. 

As these small companies become mid-size and then turn into large-cap, their shares appreciate multi-fold. For instance, share prices of Graphite India and HEG, Graphite electrode majors, surged 1,156 percent and 2,426 percent, respectively, a few years back. These multi-baggers are the coveted stocks, which are hard to find for retail investors given the limitations we have in terms of research software and trade tools. This is where small cap funds come into play and give us the opportunity to invest in such stocks and capture the gains. In this article, we will talk about: 

  1. What are Small Cap Funds?
  2. Key Differences
  3. Advantages & Disadvantages
  4. Who should invest in Small Cap Funds?
  5. How to evaluate Small Cap Funds?
  6. Top Performing Small Cap Funds on RankMF

1. What are Small Cap Funds?

Small cap funds invest majorly in the small cap category. These funds have to invest a minimum 65% of its funds in small cap companies, which tend to hav1e high growth potential as they are usually young, with an outlook for aggressive expansion. On the downside, they are more volatile than their mid and large-cap counterparts as these funds can generate sharply negative returns in times of market instability and chances of an investor losing their capital is high in small cap companies.

2. Key Differences

Categories Where do they invest? Market Cap Risks Ideal for
Large cap Large cap companies which are well-established, reputed and generally market leaders in their segments. These are financially strong and provide slow but steady growth in stock. Top 1-100 companies by size (Market cap) Moderately High risk If you are a conservative investor who wants some exposure to equity but without severe market fluctuations in your portfolio
Mid Cap Mid cap companies that have long-term competitive advantages and potential for growth 101-250th companies in terms of market cap High Risk If you have higher risk-taking ability and higher return expectations than the large cap fund investors
Small Cap Small cap companies which are particularly young and offer tremendous growth potential 251st and companies beyond Very High Risk If you are an aggressive investor with high risk-taking abilities who wants to capture price gains during a bull run and can stomach losses in market cyclicality

3.  Advantages & Disadvantages

  1. The main advantage of investing in small-cap funds is the significant upside growth potential that is unmatched by the bluechip companies with large market capitalisation under large cap funds.
  2. Exposure to small-cap funds can help boost portfolio returns as these funds tend to reward those who stay invested for a long term.
  3. There is a possibility of these stocks being undervalued since these small-cap companies are relatively new and unknown and could be available at a discounted rate.
  4. They tend to outperform the large-cap and mid-cap funds in a bull run, giving you a huge opportunity to grow your investments quickly and earn superior returns.
  1. Small-cap companies are very uncertain in nature causing severe market ups and downs in the short run making the portfolio volatile/unstable.
  2. Although small cap funds have higher opportunities for growth they come with higher risk. Therefore, these are suitable only if you have higher risk appetite or are a seasoned investor.
  3. Since small cap companies are generally growth stocks, they tend to retain all profits to reinvest them in the company. This leads to low or zero dividends.
  4. Since these stocks have low liquidity, at the time of purchase and sale, the low volumes could affect/alter the share price, thereby affecting the returns of the portfolio.

4.  Who should invest in Small Cap Funds?

The primary objective of a small-cap fund is to generate long-term capital appreciation from a diversified portfolio. These funds have a high return-risk ratio. Their underlying securities, which are small cap stocks, are more volatile than their large-cap and mid-cap counterparts. It means that after you make an investment in a small-cap fund, you may see sharp ups and downs in your portfolio. If you think you have high risk taking abilities and want to build long-term wealth by taking higher risks, you opt for these funds. These funds perform well over the long term and offer the highest growth potential with a promise of giving superior returns. If you have a short term investment horizon or cannot tolerate negative returns on your investments at certain periods, you should look for a fund for investment in a different category. Choose small cap mutual fund schemes if you have a long-term investment horizon and a high-risk appetite.

5.  How to evaluate Small Cap Funds?

1)    Measuring Fund’s Risk

The risk in mutual funds investment mainly refers to the possibility of returns being different from what you originally expected. In other words, risk indicates the volatility of returns. These risks are not consistent throughout all mutual fund schemes. The return and risk relationship changes based on a variety of factors. There are some basic risk measures commonly used to evaluate mutual funds such as alpha, beta, r-squared and standard deviation. They help in evaluating the risk associated with various schemes.

  1. Alpha: Alpha is used to find out the excess return on investment over and above the benchmark. If the alpha is zero then our current investment is equal to the benchmark. If alpha is 1 then the fund has outperformed & if it’s less than zero, then the fund has underperformed.
  2. Beta: Beta measures a fund’s volatility in comparison with the market. The volatility of the market is 1 by convention. For mutual funds, their benchmark is taken to be the market. A beta greater than 1 says the fund is more volatile than the market whereas beta less than 1 indicates it is less volatile than the market.
  3. R-squared: R-squared tells how similar a fund’s performance is to its benchmark’s or how much of the performance comes solely from movements in its benchmark. R-squared values range from 0 to 1 and are commonly stated as percentages from 0 to 100%
  4. Standard deviation: Standard deviation of a fund, expressed as a percentage, defines how much a fund’s return has varied from its average return. If a fund has higher standard deviation, its returns are expected to be much more volatile.

In the table below you will find risk measures for different small cap schemes.

Scheme Alpha Beta R-squared Standard deviation
Hdfc Small Cap Fund – Growth 0.1884 0.5544 0.0769 0.7776
Sundaram Small Cap Fund Regular Growth -0.0852 0.8937 0.0121 0.9189
Franklin India Smaller Companies Fund- Growth 0.1383 0.6809 0.0832 0.7014
Kotak Small Cap Growth Fund 0.1563 0.7212 0.0768 0.7455

*Data as per 2019 records 

2)   Expense Ratio

It is a ratio that is used to calculate the expenses involved in managing and operating a fund scheme. It is the cost per unit of managing a fund.

Eg. If you invest Rs. 1 lakh in a mutual fund at an NAV of Rs. 10 and the expense ratio is 2%, after one year, there is a gain of 15% on the NAV. So, the value of Rs. 1 lakh has gone up to Rs. 1.15 lakh.

However, after a deduction of 2% charge, the amount is reduced to Rs. 1,12,700. AMC will adjust this expense ratio of 2% in the NAV of the scheme itself so NAV will be reflected as Rs. 12.7 instead of Rs. 15, which was before adjusting the expenses. Lower the expense ratio, higher the returns & vice versa. 

Some of the expense ratios for the small cap scheme are as below:
Scheme Expense Ratio
Sbi Small Cap Fund Regular Growth 2.44%
Reliance Small Cap Fund – Growth 2.3%
Dsp Small Cap Fund – Growth 2.12%
Franklin India Smaller Companies Fund-growth 2.02%
Axis Small Cap Fund – Growth 2.67%
Sundaram Small Cap Fund Regular Growth 2.34%
Hdfc Small Cap Fund – Growth Option 2.18%

*Data as per 2019 records

3)   Risk-adjusted returns

Returns should be risk-adjusted as small-cap funds carry risk but there are some funds that can manage risk better than their peers. Ratios such as Sharpe ratio, Sortino ratio, Information ratio, etc. are used to identify funds with the potential of generating good returns and low volatility.

4)  Expertise of the Fund Manager

The expertise and skill set with which a fund manager manages a fund has a huge impact on its performance and the portfolio over time. You should look for a fund manager with a strong track record across market ups and downs and his investment experience.

5)   Ratings

With the market fluctuations, the valuations and the margin of safety keep changing. The ratings on RankMF can help you assess the quality of the portfolio holdings and help you know which fund is the right one to invest in. For instance, if a fund was holding great companies, but were expensive earlier and the market corrects fast , which brings these companies at a fair valuation, then the fund becomes more investable and the score of the fund and the ratings of the fund would improve. 

6.  Top Performing Small Cap Funds on RankMF

Here are the top performing small cap schemes for you.

Scheme name 3-Year Return 5-Year Return
Sbi Small Cap Fund Regular Growth 18.83% 28.41%
Reliance Small Cap Fund – Growth Plan – Growth Option 18.68% 25.98%
Dsp Small Cap Fund – Regular Plan – Growth 11.77% 23.23%
Franklin India Smaller Companies Fund-growth 13.24% 21.25%
Axis Small Cap Fund – Regular Plan Growth 13.53% 21.01%

*Data as per 2019 records

With this, we conclude our discussion on the topic of Small Cap Funds. For more information about investing in mutual funds, stock trading and useful related articles, visit RankMF.com or our investor education centre.

(Note: This content is for information purpose only. Avoid trading and investing based on the information given above. Before investing in stocks or mutual funds, please conduct proper due diligence).

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