How to choose the right Small Cap funds for you?

Equity mutual funds are the perfect solution for people who want to own stocks without doing their own research.

(A) What is Small Cap Mutual Fund ?

Small Cap Funds invest a major portion of their investible corpus into equity or equity-related instruments of small-cap companies. According to the Securities and Exchange Board of India (SEBI), small-cap schemes need to invest at least 80% of their total assets in small-cap companies.

It is important to note that small-cap funds carry a high level of risk. Even the slightest volatility in the market can hugely impact the share prices of small-cap companies. However, these stocks also have a huge potential to offer amazing returns.

(B) Who should invest in Small Cap Funds?

Usually, many investment advisors recommend investors to dedicate a small portion of their portfolio towards small-caps. This is because small-cap stocks offer a great opportunity to earn huge returns. It is important to be patient while investing in small-cap schemes. Remember, small companies can need time before they become the next large corporation in the country and help you earn great returns on your investment.

One thing is clear, you should opt for Small Cap Mutual Funds only if you have higher risk tolerance.

(C) Parameters to Analyze before investing in Small-Cap Mutual Funds

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(i) Fund Performance vs Benchmark Performance

This is one of the first things most investors check for in a scheme.

However, what percentage return indicates a good performance? How do you know whether your selected fund has performed well or not?

The performance of a particular fund must always be compared with the performance of the respective benchmark for the fund. Each scheme necessarily has a benchmark, which it aims to outperform. Since you are investing your hard-earned money, you will expect your fund to beat its benchmark and create higher Alpha. 

Hence the first parameter while analyzing a mutual fund is to select funds that have consistently outperformed its benchmark.

(ii) Total Expense Ratio

The expense ratio is the percentage of total assets that a mutual fund charges an investor annually for managing their money.

The expenses related to Mutual Funds fall into 5 categories-

• Distribution charges;
• Security transaction fees;
• Management fee;
• Investors transaction fee;
• Fund service charges.

Basically, the expense ratio reduces the returns available to the investor. Therefore, an investor should look for funds with a lower expense ratio.

(iii) Strength of the fund

Strength of a fund is analyzed by an indicator called Strength Indicator. It is an indicator which tells that how resilient a scheme is in market volatility and its ability to generate a higher return at lower risk using ratios such as standard deviation, Sharpe ratio, etc.

• Standard deviation – refers to the volatility of a fund. Higher the standard deviation, the more volatile the returns will be. This means you should choose the funds with the least St. dev.
• Sharpe ratio – refers to the additional returns generated by the fund per unit of risk taken. A higher Sharpe ratio means better risk-adjusted returns for the investor. So, it is advisable to choose fund whose Sharpe ratio should be at least higher than its benchmark.

(iv) Study the fund’s Beta

The Beta measures the risk involved in a fund.

• Beta > 1 = the fund gains or loses more than the benchmark.
• Beta < 1 = the fund gains or loses less than the benchmark.

(v) Rolling Returns Analysis

You must have heard the line ‘past performance is not an indicator of the future performance’, while this is true, there is no better alternative to this. By studying the past returns and its behavior, we would at least know what to expect.

Let’s analyze it with an example, we can see in last 3 years Nifty Small-cap 250 has an average rolling returns (260 days) of 49.88% while Nippon India Small-cap has an average returns of 57.06%.

We can also check the highest and lowest returns of the fund against the benchmark in the above table. Meanwhile, the +ve% is the percentage of all the rolling returns that are positive.

(vi) Fund Manager

Apart from the above-mentioned points, there are some other aspects which can also be looked upon.

The performance and history of the fund manager are crucial. An investor can look at the experience that the fund manager has, other schemes that the fund manager is managing and so on.

This increases the reliability and confidence that your hard-earned money is in safe hands.

Moreover, the reputation and history of the fund house, under which the scheme belongs can also be looked upon.

(D) Conclusion

Knowing what to look at while evaluating a mutual fund, leads to the selection of a good mutual fund. This knowledge can go a long way in helping you make the correct investment.

It must always be kept in mind that investment in mutual funds is subject to market risks. Therefore, proper due diligence is beneficial.

If you still find difficulty in selecting a mutual fund you can consult a financial advisor, who can guide you based on your risk profile.

Drop us your query at – info@pawealth.in or Visit pawealth.in

References: Updates from Mutual Fund Companies.

Disclaimer: The report only represents the personal opinions and views of the author. No part of the report should be consider a recommendation for buying/selling any stock. Thus the report & references mentioned are only for the information of the readers about the industry state.

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