Is it worth buying small cap mutual funds?

Last Updated on October 14, 2021 at 8:40 am

In this article, we present the results of a performance analysis of small cap mutual funds compared to the Nifty Smallcap 250, NIfty MIdcap 150 and Nifty Next 50 total returns index. We discuss if it is worth investing in small cap mutual funds.

We had recently reported that active mid cap mutual fund managers struggle to beat a mid cap index – Myth Busted: Active mid cap mutual fund managers can easily beat the index. Is it any easier to beat the index in the small cap stock universe?

For this study, we use one, two, three, four and five-year rolling return analyses. That is, we consider every possible 1,2,3,4 and 5-year return possible between 1st January 2013 (inception date of direct plans) and 12th October 2021.

We then define a rolling return performance consistency ratio as

No of returns duration a fund has beat the index divided by the total no of return durations.

For example, SBI Small Cap Fund Direct Plan has outperformed the Nifty Small Cap 250 TR Index 1396 one-year periods out of a total of 1695 periods. So the rolling return performance consistency ratio is 1396/1695 = 82%.

Considering the fee removed from the market value of our investments daily, it is reasonable to expect a 70% outperformance over 3,4 and 5 years. Note that 50% outperformance = 50% underperformance = coin toss! We also removed funds like Quant Smallcap (link points to fund review), a debt fund not too long ago!

Small cap funds vs Nifty Small cap 250 TRI

• Five years: 11 out of 14 small cap funds beat the Nifty Small cap 250 with more than 70% outperformance consistency.
• Four years: 11 out of 15 (same criterion)
• Three years: 11 out of 15 (same criterion)

That is a significant improvement when compared with the midcap space. However, it is too early to rejoice.

Small cap funds vs Nifty Mid cap 150 TRI

These results are sourced from Equity Mutual Fund Screener Oct 2021.

• Five years: 4 out of 14 small cap funds beat the Nifty Midcap 150 with more than 70% outperformance consistency.
• Four years: 4 out of 15 (same criterion)
• Three years: 2 out of 15 (same criterion)

Why compare small cap funds with a mid cap index? Ask yourself, “why do you want to invest in small cap funds? Why take on more risk?”. Obviously, the idea is to get more returns than a mid cap fund.

It should be clear from the above that the Nifty Smallcap 250 index is too easy to beat. Things are pretty tough when a mid cap index is used. This points to the inefficiency of investing in active or passive small cap mutual funds (sadly the same argument also applies to mid cap funds too as established before).

At the very least, it points to the inefficiency of buying and holding small cap funds (SIP investing is also buy and hold!) as demonstrated before: Why a SIP in Small Cap Mutual Funds is a waste of money and time.

There are tactical buy and sell approaches that fare better but with higher risk – Do not use SIPs for Small Cap Mutual Funds: Try this instead! Also see This “buy high, sell low” market timing strategy surprisingly works!

Small cap funds vs Nifty Next 50 TRI

• Five years: 6 out of 14 small cap funds beat the Nifty Next 50 with more than 70% outperformance consistency.
• Four years: 6 out of 15 (same criterion)
• Three years: 3 out of 15 (same criterion)

Now, why would I invest in a small cap fund (active or passive) when I can get a reward vs risk deal and lower expenses with Nifty Next 50?

In summary, these results point out that it is not worth investing in active or passive small cap funds. So what is the alternative?  Active mid cap funds are struggling to beat the mid cap index. Passive mid cap options are plagued with tracking errors. Therfore a Nifty Next 50 index fund remains the most straightforward and most efficient choice for anyone who wants to take on more risk than the NIfty or Sensex for potentially higher reward over the long term.