Why investing in small cap mutual funds does not make sense!

Last Updated on September 5, 2022 at 4:44 pm

In an update to our earlier reports, we compare the performance of actively managed small cap mutual funds with four benchmarks and discuss why it does not make sense to invest in small cap mutual funds.

We shall compare every possible 3-year, 4-year and 5-year return of small cap funds between 1st Jan 2013 and April 13th 2022 with (1) Nifty SmallCap 250 TRI; (2) Nifty Midcap 150 TRI; (3) Nifty Next 50 TRI and (4) Nifty Midcap 150 Quality 50 TRI.

You may possibly be thinking, “how does it make sense to compare a small cap fund return with mid cap indices or Nifty Next 50?” If we were an analyst trying to publish a report or a researcher trying to publish a paper, we will most likely stop the comparison with NIfty Smallcap 250 TRI.

However, we are not all those here. We are investors trying to see which option offers the highest reward at the lowest cost and possibly lower risk.  Before we look at the results, please answer this question.

You are considering adding a small cap fund to your portfolio but realise (ahem, thanks to us) that most small cap funds struggle to beat Nifty Next 50 or Mid cap indices. What would you do?  Would you go ahead and “diworsify” your portfolio with a small cap fund with the unfounded claim that “in the long term” small cap is better than mid cap which in turn is better than large cap? For some data see: Large Cap vs Mid Cap vs Small Cap Funds: Which is better for long term investing? Or you would keep your portfolio simpler with a large cap fund + mid cap fund?

Now, that you have a sense of what to expect below, let us dive in. There are a total of 25 actively managed small cap funds. However, only 14 of them are “old” – defined as having at least 500 or more 3Y or 4Y or 5Y rolling return data points.

We shall use Rolling return outperformance consistency for the study. The fund returns are compared with category benchmark returns over every possible 3Y,4Y, 5Y period. 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 shall expect 70% outperformance to justify the fee charged by active small cap mutual funds. Analysis such as this for all equity funds can be found here: Monthly Mutual Fund Screeners. You can use these equity fund screeners to change the outperformance consistency to any number if you do not agree with our 70% definition.

Small Cap Funds vs Nifty Small Cap 250 TRI

• Three years: 10 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Four years: 9 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Five years: 11 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Three + Four + Five years: 9 out of  14 funds have a 70% or more Rolling return outperformance consistency

That is certainly not bad. Active small cap fund managers find it reasonably easy to beat Nifty Smallcap 250 TRI.

Small Cap Funds vs Nifty Midcap 150 TRI

• Three years: 2 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Four years: 4 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Five years: 4 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Three + Four + Five years: 2 out of  14 funds have a 70% or more Rolling return outperformance consistency

Notice the dramatic drop in performance.

Small Cap Funds vs Nifty Next 50 TRI

• Three years: 3 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Four years: 5 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Five years: 7 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Three + Four + Five years: 3 out of  14 funds have a 70% or more Rolling return outperformance consistency

A bit better versus the Nifty Next 50 but still far from good enough!

Small Cap Funds vs Nifty Midcap 150 Quality 50 TRI

• Three years: 1 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Four years: 2 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Five years: 3 out of  14 funds have a 70% or more Rolling return outperformance consistency
• Three + Four + Five years: 1 out of  14 funds has a 70% or more Rolling return outperformance consistency

That is the worst performance similar to actively managed mid cap funds. See: How many mid cap funds outperformed Nifty Midcap 150 Quality 50 Index?

Do these results represent the superiority of the quality factor? No. They represent the inferiority of active human management when compared to a set of fixed (and arbitrary!) rules. Read more: UTI Nifty Midcap 150 Quality 50 Index Fund Review.

Since it is impossible to know which small cap fund will emerge the winner tomorrow and since we already have low cost-efficient index fund options in the mid cap space (Nifty Next 50 is also a mid cap index. See – Warning! Nifty Next 50 is NOT a large cap index!) which have given better returns, why would I buy an active small cap fund? The odds of these funds outperforming a low-cost mid cap index are far from reasonable!

Does this mean, I can switch from an active small cap fund to a mid cap index fund? Yes, but some caution is necessary. Index funds beyond the top 100 stocks are plagued by huge tracking errors.

• So we do not recommend using Nifty MIdcap 150 Index funds as they can have large tracking errors.
• We also do not recommend Axis Nifty Midcap 50 Index fund (link points to our review) as it is an underperformed relative to Midcap 150.
• We do not recommend any ETFs because of liquidity issues and price-NAV deviations. Also, see ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!

So then what?!

• If you are not comfortable with factor-investing and the arbitrary cherry-picked nature of their construction  – Data Mining in Index Construction: Why Investors need to be cautious -, then we recommend using Nifty Next 50 as a mid cap option. Naturally, this comes with risks that must be understood. See: Is it time to exit from Nifty Next 50?
• If you are comfortable about taking a chance with the quality factor, then you can consider UTI Nifty Midcap 150 Quality 50 Index Fund. Please be aware that this comes with its own set of risks (eg. curation risk – see, for example: Should I exit Nifty Next 50 because of Paytm, Zomato and Nykaa?), tracking error and higher fee.

What about my existing small cap funds? I have a ‘fear of missing out’ and don’t want to stop investing? Then at least do not blindly buy hold! Have a tactical entry and exit strategy such as this: Do not use SIPs for Small Cap Mutual Funds: Try this instead!