HDFC Small Cap Fund Review: Impressive but too young?

Published: March 31, 2019 at 10:54 am

Last Updated on December 29, 2021

This is a review of HDFC Small Cap Fund. Currently rated 5 stars by Value Research (hence the interest among readers to know more), the fund fell the least since Jan 2018 when the small cap index went south. However, there is more to the fund than that meets the eye. I write this article primarily to point this out.

Like most mutual funds, HDFC Small Cap has also seen rapid growth in AUM -partly due to inflow and partly due to the growth of small caps. According to Motilal Oswal Investment Services, the AUM was a mere 772 Crores in Feb 2016. It increased to 946 Crores in Feb 2017. A year later it was 2669 Crores (Feb 2018)!! Another year later (during which small cap stocks fell), the AUM rose to 6311 Crores!! So much of it due to inflow. Is this a case of hard selling and herd investing after the up movement is over? I think so.

HDFC Small Cap Fund Review: Impressive but too young?

HDFC Small Cap Fund AUM Movement

AUM growth of HDFC Small Cap Fund


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History of HDFC Small Cap Fund

• It was a multi-cap fund launched by Morgan Stanley (A.C.E. Fund )on April 3, 2008
• When HDFC acquired Morgan Stanley, they made it into a mid and small cap fund
• On November 2016 they then changed it into a small cap fund

The main reason I am writing this post is to point out that the fund has operated as a small cap fund only from Nov 9th 2016 onwards and even during this period, because of the fall since Jan 2018, it has had considerable exposure in mid caps. Therefore always consider the history of the fund before looking at returns and taking star ratings seriously.

Investment Strategy

According to the scheme presentation,

The focus is on well managed small cap companies.
• Businesses operating in a niche environment.
• Identify businesses at a relatively early stage in their life-cycle.
• Focus on quality metrics like ROCE & ROE.
• Invest predominantly in small cap companies.
• Identifying companies with reasonable growth prospects.
• Identify companies with sound financial strength and sustainable business.
• Seek undervalued businesses.

HDFC AMC misrepresents small cap risk!

Have a look at this slide from the presentation file

Small cap vs Mid cap vs Large cap volatility comparison as claimed by HDFC MF AMC

It first says (using cherry-picked data):

Volatility exhibited by the Small Cap benchmark is in line with large and midcaps

Then cautions at the bottom of the slide:

Small Caps carry a higher risk of market fluctuations and are also prone to higher liquidity risks. Small caps are strictly not comparable to Large caps stocks

Just for this, I would not invest in this fund.

The reality of small cap risk

This is the 10-year rolling risk (standard deviation) of Nifty Small Cap 100 vs Nifty Midcap 100 and other Indices as indicated below. Notice how the small cap index is distinctly more volatile.

rolling Volatility comparison of Small cap, mid cap and large cap indices

HDFC Small Cap Fund vs Benchmark

This is a screenshot from Value Research since the time the fund operated as predominantly small cap. That is impressive but also means the fund has held a good amount of mid cap stocks throughout this period

HDFC Small cap fund vs benchmark normalized NAV movement

The usual rolling risk and return graphs cannot be applied due to the short history of this fund.

HDFC Small Cap Fund vs Peers

The normalized NAV movement since 9th Nov 2016 is shown for HDFC Small Cap and other peers. The fund has protected investors well during the fall

HDFC Small Cap fund vs peers normalized NAV movement

Video Version

Summary

Although the fund has protected investors during the fall in small caps from Jan 2018, I do not think the fund has operated long enough as a small cap heavy fund. It may never do that and that is not a bad deal for investors. However, it is still early days.

If you look past the misrepresentation of product risk mentioned above, there are three choices:

  1. Stay away from small caps (recommended)
  2. Shop for a small cap fund like Franklin India Smaller Companies Fund Review: Performance with low volatility. This has the track record (relatively although it too had a bad past as a closed-ended fund)
  3. Take your chances with this fund.

If you want a choice between 2 and 3, the go with Franklin Smaller Companies fund. Since Franklin does not have a bank and demat service to push funds, its AUM growth could possibly be slower than this fund in future. However, my choice is (1) stay away from small caps.

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