Small-cap stocks, and by extension, actively managed small-cap funds, offer investors the potential for better returns than from large-caps. But investors must brace themselves for higher return volatility in the small-cap space, especially over shorter investment periods and in times of uncertainty. The stock market crash following the Russian attack on Ukraine gave investors a taste of this.

Small-cap index funds that passively copy an index, can, however, be a different ball game altogether. That is, they too can expose investors to volatile returns – but with the added disadvantage of a higher possibility of lagging market returns. Data shows that small-cap index returns can be wide-ranging, dipping into the negative zone too, across different holding periods.

If you want exposure to small-caps, actively managed funds can provide a better alternative to passive index funds.

Being passive doesn’t help

A few AMCs introduced small-cap index funds tracking the Nifty Smallcap 250 TRI (total return index) in recent years. The latest to be launched is Axis MF’s Nifty Smallcap 50 Index Fund. The new fund offer closes on March 7, 2022.

The Axis Nifty Smallcap 50 Index Fund will track the Nifty Smallcap 50 TRI. The index comprises top 50 companies selected based on their average daily turnover from the top 100 full market cap companies from the Nifty Smallcap 250 Index. While the Nifty Smallcap 50 TRI is constructed in a way to include only the most liquid small-cap stocks with higher weights assigned to those with a larger free float market cap, data on the actual performance of the index leaves much to be desired.

Higher volatility, lower returns

A rolling returns analysis (daily rolled returns) shows that the Nifty Smallcap 50 TRI has delivered, on average, 1-year return of 17 per cent (CAGR) over the last seven years. While the average return looks impressive, do note the wide range of these returns – from minus 49 per cent to 158 per cent – during this period. That is, depending on the 1-year period that you chose to remain invested in over the course of the last seven years, your return could have been anywhere between this wide range. The index’s 3-year and 5-year average returns, though not as wide-ranging as the 1-year returns, are modest.

A comparison with the Nifty 50 TRI puts these numbers in context (see table). The large-cap index has returned, on average, 3-year and 5-year returns (CAGR) of 12 per cent, each, significantly higher than the respective returns of the small-cap index. Along with higher average returns, the Nifty has also had a narrower range of returns (that is, less volatile returns) and far fewer instances of negative returns compared to the small-cap index. This leaves no compelling case for investing in a Nifty Smallcap 50 Index Fund. This is particularly so, when seen in the context of the good performance record of many actively managed small-cap funds.

Stay active

Those with a high risk appetite can invest in one of the well-performing actively managed small-cap funds through SIPs. Small-cap funds from SBI MF and Axis MF figure among the top performers. These funds have generated average 3-year returns of 14-15 per cent and 5-year returns of 16-17 per cent (CAGR) over the last seven years based on daily rolled returns. The two funds’ 3-year returns have been negative less than 2 per cent of the time, and 5-year returns, never, over the last seven years. More importantly, even the laggards among the active small-cap funds have fared better than the Nifty Smallcap 50 Index – in terms of higher average 1,3 and 5-year returns and far fewer instances of negative 1,3,5-year returns – over this period.

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