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The Sebi circular in end 2017 on categorization and rationalization of various mutual fund schemes mutual fund schemes led to a a virtual blow to Small Cap Mutual Funds. The flexibility that Mutual funds enjoyed in investing across various market caps stood severely restricted. Earlier many funds which overtly had a large cap label, used to invest in small cap stocks to boost returns. Not only they were disallowed to do so, but they were also given a time period to align their portfolio to the new norms. The resulting reorientation of Mutual funds portfolio and rejig of schemes carried in first half of 2018, led to drying up of flows into several small-cap funds as well as wide sell off in small cap stocks.

Small Cap funds were now mandated by SEBI to invest at least 65% of their corpus in small cap stocks. As per SEBI definition, Small cap stock start onwards after first 250 stocks in terms of market capitalization. With new categorization in force, investors and analyst alike considered Small cap Mutual Fund schemes as risky as they did not offer commensurate returns to justify the extra risk being taken by investors. As per Sebi new norms, small cap mutual funds are mandated to invest at least 65 per cent of their corpus in small cap stocks. The impact reverberated not only in small cap mutual fund schemes but also led to a large sell of in small cap stocks as funds which earlier carried a mix of large cap, mid cap and small cap stocks had to make choice of a specific category with each Mutual fund house being allowed only one scheme in each category.

Bench marking Changes

Many Mutual Funds had long been claiming that their funds were able to outperform returns from market as measured by performance of benchmark Indices. These indices were not truly reflective of returns from market as they took into account capital appreciation only and did not account for dividends etc. Thus to correct this anomaly, from February 1, 2018 SEBI the watchdog for Indian Mutual Fund Industry mandated that all fund houses will have to benchmark their equity and balanced funds to Total Returns Index (TRI) instead of then prevailing practice of bench marking against Price Return Index (PRI). Total Returns variant of an Index (TRI) in addition to capital gains, also takes into account all dividends/ interest payments that are generated from the basket of constituents that make up the index . Hence TRI is more appropriates as a benchmark to compare the performance of mutual fund scheme.

Now investors can judge extra return if any ( Alpha ) generated by the fund manager with respect to TRI adjusted Benchmarks. Alpha is a measure of the value added by the fund manager, for the same amount of risk. Needless to say that number of fund houses which were claiming to have outperformed benchmarks, will now fall drastically after making a comparison with the TRI instead of the PRI (normal indices).

Small Cap Funds: Are they still relevant

• Investors first need to set their investment objectives and risk tolerance level . For investors having a lower risk tolerance level, the Mutual fund portfolio should be biased in favor of large cap funds.
• Small cap fund scheme carries a moderately high risk. The small cap stocks are rather volatile and risky.
• Small cap Mutual fund schemes are not suitable for conservative equity  investors. 
• Investors with an aggressive risk appetite can still consider these equity small cap mutual fund investment.
• Small cap stocks are currently not favorite which leaves scope for upside in future in line with their performance.

Top small cap Mutual Funds by AUM

There are 6 large cap Mutual Funds based on criteria of AUM > 1000 crore and those which generated positive returns in last 3 years which is a reasonable period to measure performance. Some of the major small cap funds which do not make it to this list include DSP Small Cap Fund, Aditya Birla Sun Life Small cap Fund, Sundaram Small Cap Fund and Franklin India Smaller Companies Fund. Data given pertains to Direct Growth schemes of these mutual funds and all returns indicated are in percentage annualized basis.

HDFC small cap and L&T emerging markets have low Expense ratio which may be primarly due to higher AUM.

Small Cap Mutual Fund Performance vs Benchmarks

Direct Growth schemes of Mutual Funds have been considered and all returns indicated are % annualized Returns

Small Cap Mutual Funds: Statistical Measures

There are many parameters that are used to measure the volatility in performance and risk adjusted performance of a fund. We here limit ourselves to two statistical indicators alpha and beta.

In simple terms , Alpha represent the value that a fund manager adds or subtracts from a fund portfolio’s return. An alpha of 1.0 means the fund has outperformed its benchmark by 1%. Similarly , an alpha of -1.0 would indicate an under performance by the fund by 1%. 

Beta is a measure of the volatility, or the systematic risk of the fund portfolio with respect to the market in totality. A beta near to 1.0 indicates that the funds investment’s value will move in tandem with the market. A beta of less than 1.0 indicates that the funds NAV is less volatile than the market or benchmark. Correspondingly, a beta of more than 1.0 indicates that the funds NAV is more volatile than the market. A fund with beta of 1.3 is theoretically 30% more volatile than the market. Thus mutual fund schemes with a a higher alpha and lower beta are considered as better performers under this framework.

Axis small cap and SBI small come out better with a higher alpha and lower Beta. Axis small cap has the lowest beta in 3 year period.

Small Cap Mututal Funds Vis a Vis others

Average category returns (% annualized) over different time periods are depicted below

Average Performance of small Cap and Mid cap categories has lacked the other categories though in longer 5 year period they more or less mirror similar returns.

Assessment

• The SEBI Categorization and resultant limits imposed on various funds have turned the odds heavily against small cap Mutual Funds.
• With Small cap Mutual now attracting much less fund inflows, other categories restricted from buying small cap stocks, buying support for even good small caps is not high resulting in below average market valuations.
• Compared to Small cap funds, “multi-cap Funds” and “Large and Mid cap funds” categories, have much more flexibility to invest and therefore some of these funds need to be considered by investors.
• Small-cap funds can invest in small cap stocks which sometimes have significant potential to be a “multi-bagger”. However in a market meltdown they carry a heavy risk of capital erosion.
• With re categorization and TRI based bench-marking in force, small cap funds have lost most of their sheen and now attract investors with long term horizon and those with higher risk appetite. The Funds may still be suitable for a longer investment horizon typically extending over few years to achieve long-term financial goals. 
• Nevertheless an investor can plan to dedicate a small portion of his folio to a good performing small cap funds as values of many small caps is relatively reasonable and their returns can differ from other categories thus providing an element of diversification.