Active Small Cap Funds vs Nifty Smallcap250 Quality 50 Index

We compare the performance consistency of actively managed small-cap mutual funds with the Nifty Smallcap250 Quality 50 Index. We recently discussed the performance of this index here: DSP Nifty Smallcap250 Quality 50 Index Fund Review.

According to the NSE, “the Nifty Smallcap250 Quality 50 Index tracks the performance of small cap stocks selected based on their quality scores. The quality score for each company is determined based on return on equity (ROE), financial leverage (Debt/Equity Ratio) and earning (EPS) growth variability analysed during the previous 5 years. The index includes up to 50 stocks selected from the parent Nifty Smallcap 250 index based on the high-quality score.  The weight of the stock in the index is derived by multiplying the square root of the free float market cap with the quality score of
that stock”.

Regular readers may be aware that we have repeatedly cautioned about the arbitrary nature of the “quality” factor and the problem of Data Mining in Index Construction ( Why Investors need to be cautious).

Also see:

• Why Nifty Midcap150 Quality 50 index performance is a warning for factor investing fans
• DSP Nifty Midcap 150 Quality 50 Index Fund Review
• UTI Nifty Midcap 150 Quality 50 Index Fund Review

Therefore, investors should not take any pitch that goes, “This fund invests in quality small cap stocks” seriously.

Readers may also know about our stance against all small cap funds: Is there any proof small cap mutual funds would outperform in the long term? Also, Why are you not recommending mid cap and small cap funds?

Disclaimer: Fund performance reports present return and risk analysis of a fund with representative benchmarks and not investment recommendations. It must be expressly understood that the data below reflect only past performance and is in no way an indication of future performance. Our investment recommendations are as follows: Handpicked List of Mutual Funds (PlumbLine).

Rolling return outperformance consistency: the small cap fund returns are compared with category benchmark returns over every possible  3Y,5Y, 7Y, 9Y period from 1st Jan 2013. The higher the outperformance consistency, the better. Suppose 876 fund returns were compared with 876 benchmark returns, and the fund has beaten the benchmark 675 times. The consistency score will be 675/876 ~ 77%.

We expect a 70% outperformance consistency score from an active small cap fund. After all, they claim the fund manager can pick the right stocks and charge a premium for them. So they better perform.

• Nine years: 6 out of 13 funds quality with greater than or equal to 70% rolling return outperformance consistency when the Nifty Smallcap250 Quality 50 Index is used as the benchmark.
• Seven years:  6 out of 14 funds qualify with the same criterion.
• Five years:  8 out of 17 funds qualify.

We repeated the same study with regular plan small cap funds. This allows longer periods to be studied, but the higher expense ratio (compared to direct plans) will affect the results.

• Fifteen years: None out of 7 funds qualify.
• Twelve years: 1 out of 8 funds qualify.

Half or less than half of the active small cap funds fail to beat the Nifty Smallcap250 Quality 50 Index consistently. So can I invest in DSP Nifty Smallcap250 Quality 50 Index Fund instead of active small cap funds?

We reiterate that a small cap fund of any kind is not necessary for a portfolio. A flexicap fund offers all the exposure to small cap stocks one needs. If you “must” have a small cap fund in your portfolio, the DSP Nifty Smallcap250 Quality 50 Index Fund can be considered a low-cost alternative to an actively managed small cap fund.

However, it must be clearly understood that “quality” does not mean consistent outperformance. DSP Nifty Smallcap250 Quality 50 Index Fund could underperform a small cap 250 index fund or active small cap funds occasionally and for long periods.