Mutual Funds

Should you invest in ICICI Pru Smallcap Index Fund?

Maulik Madhu BL Research Bureau | Updated on October 23, 2021

Index investing is not your best bet in small caps

ICICI Prudential Mutual Fund has launched its Smallcap Index Fund, a passively managed fund that will replicate the Nifty Smallcap 250 Index. The index comprises 250 companies, ranked 251 to 500 in the Nifty 500 list.

Two other existing schemes by Motilal Oswal MF and Nippon India MF, too, track the same index.

ICICI Pru MF’s new fund offer, currently open, closes on October 27, 2021. While the new scheme can provide a comprehensive and purely smallcap exposure, given the heterogeneity of this segment, investors may be better off with a top-performing, actively managed fund. SBI Small Cap and Axis Small Cap are two such funds.

Small-cap charm

The attraction of small-cap companies lies in their potential for high growth given their small size and the opportunity for exposure to emerging businesses and themes with a small / no presence in the large-cap space. As of September 30, 2021, the top five sectors in the Nifty Smallcap 250 Index were financial services (17.5 per cent), industrial manufacturing (12.8 per cent), consumer goods (11.8 per cent), IT (9.7 per cent) and chemicals (7 per cent). The large-cap Nifty 100 Index has a very different composition.

Financial services accounted for 35 per cent, IT for 15 per cent, consumer goods and oil and gas for 11-12 per cent each and metals for 4.5 per cent.

Notwithstanding their potential, not every smallcap stock is a wealth creator and careful stock selection is crucial. For instance, over the last one year, while the Nifty Smallcap 250 Index returned close to 100 per cent, individual stocks in the index generated returns ranging from minus 29 to 1,586 per cent. Likewise, compared to the index’s 3-year and 5-year returns of 100 per cent and 95 per cent, the individual stock returns varied from minus 88 to 2,770 per cent and minus 74 to 2,263 per cent, respectively.

Active vs passive

Also, while the relatively small weight of each stock in an index of 250 constituents may appear to provide ample diversification, it may in fact lead to over-diversification. The well-performing small-weighted stocks may not contribute much to the scheme’s performance. As of September-end 2021, the top five stocks in the Nifty Smallcap 250 Index accounted for only 7 per cent of the index. The top five stocks of actively managed smallcap funds, instead, accounted for 14 to 25 per cent of the fund portfolios.

Based on past performance, many actively managed smallcap funds have outperformed the Nifty Smallcap 250 TRI. A rolling returns analysis over the last seven years shows that, on an average, the top 5 funds have delivered higher returns (see table). The probability of negative returns too has been lower. The funds’ 5-year returns were negative less than 1 per cent of the time versus 12 per cent of the time for the index. Only 14 funds with at least 7 years’ history have been taken here (top 5 include the earlier mentioned funds).

Large vs smallcap

If we go back to April 2005, since when the Nifty Smallcap 250 Index data is available, we find the index has underperformed the largecap index, too, most of the time.

A rolling returns analysis shows that the Nifty Smallcap 250 Index’s all possible 3-year, 5-year and 7-year returns over the last 16 years have exceeded the respective returns of the Nifty 100 Index, only 40 per cent, 39 per cent and 50 per cent of the time. This underperformance was also accompanied by sharper drawdowns for the smallcap index in all years. Steeper the drawdown, greater the index volatility. The maximum drawdown graph shows, for each year, the maximum fall in an index value from its previous peak.

So, unless you time your entry and exit into the smallcap index, the risk-reward trade-off is unlikely to be favourable. The March 2020 low was one such opportunity. But now may not be the best time to enter this space, especially via a wide basket of stocks.

One point to note, though is that unlike an actively managed fund, asmallcap index fund provides you pure smallcap exposure. As of September-end 2021, the 14 smallcap funds had smallcap exposure of 66-86 per cent.

Published on October 23, 2021

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