Outside sectoral and thematic funds, India’s small-cap funds are the worst performing year to date. Based on the category average, this set of funds, quite popular among investors for delivering high returns, has hardly moved since the beginning of this year. With stock markets at all-time highs again, will small cap funds play catch up ? That’s the question in investors’ mind. Here are 5 charts to give you a perspective

Known for strong rebounds

Going by trends in the last decade, years such as 2013 and 2018-19, in which smallcaps were beaten down, were followed by years of outsized returns. Considering that small-caps have corrected in 2022, it may be a good time to utilise this fall and start building one’s small-cap portfolio.

Do note that small-cap investing comes with its share of volatility, since returns are higher too.

Growing in step with overall market

Naysayers will complain that small-caps are smaller companies. That could have been the same argument used by foreign investors when they considered the Indian stock market on the whole. As India’s equity market capitalisation has increased, small-cap as a segment has also witnessed an upward shift in market cap (m-cap). For the uninitiated, small-caps today are usually stocks that come 251st and onwards in the overall m-cap pecking order. Take a look at how the size of m-cap of the 251st stock and 100 securities after it i.e. the 350th stock has moved over the last 10 years.

When smaller companies transition to large-caps, investors reap the twin benefits of earnings growth and valuation multiple expansion. Remember what happened to the Bajaj Finance, Britannia, Eicher Motors, Shree Cement stocks? Many of these were too small at one point in time. The same was the case with Astral, Minda Industries, Aarti Industries, Relaxo Footwear, APL Apollo, PI Industries and Kajaria Ceramic.

High beta is high alpha

Small-cap funds, which are mandated to have 65 per cent of assets in small-cap stocks, have reaped rich rewards historically. Due to their mandate, across category, small-cap funds have over 75 per cent exposure and this has helped them beat their respective benchmarks vis a vis peers such as large-cap funds, mid-cap funds or flexi-cap funds.

In the last 1 year, 83 per cent of small-cap mutual funds have outperformed the benchmark, with the top one delivering an alpha of as much as 15 percentage points.

Downside capture within limits

A common fear about small-cap funds is higher downsides. But, a look at downside capture data shows a slightly different picture. Small-cap funds do not capture a lot of downside. Downside capture ratios are calculated by taking the fund’s monthly return during periods of negative benchmark performance and dividing it by the benchmark return. Because small-cap fund portfolios, on an average, do not have a huge number of stocks unlike their benchmarks, they appear to have been better off.

One can argue that individual small-cap funds have higher downside capture. Hence, selecting the right fund is important. At bl.portfolio Star Track MF ratings, we currently assign 5 stars to the Quant Small Cap Fund and SBI Small Cap Fund, and 4 stars to the Axis Small Cap Fund and Nippon India Small Cap Fund. 

Performance of small-cap funds

Finally, here is a look at the biggest small-cap funds performance over 3, 5 and 10-year periods. While point-to-point historical returns do not have much bearing on what the future may hold, they do serve as a guidepost in terms of stability and consistency of returns. The returns tell you why investors prefer to add small-cap funds to their portfolio. This is a better way to add small-cap exposure compared to direct small-cap equities.

Happy Investing!