Is there any proof small cap mutual funds would outperform in the long term?

Published: October 27, 2023 at 6:00 am

Every time stocks in the small cap universe move up prominently, interest in small cap mutual funds and confidence in this sector zoom up even more. Notions like “A small cap mutual fund will beat all other categories (and indices) over the long term” start making the rounds among gullible young earners who naively believe we can compensate low investment amounts with returns.

But is there any proof that small cap mutual funds would outperform in the long term? The short answer is no. Our stock markets are quite young.  The Nifty Smallcap 250 index was launched only in April 2016! The data we have of that index from April 2005 is backtested.

Even within this short period, the small cap index has always underperformed the Nifty Midcap index of 10-year rolling returns.  See Nifty vs Nifty Next 50 vs Nifty Midcap 150 vs Nifty Smallcap 250.

10 year rolling returns of Nifty Next 50 TRI and Nifty Midcap 150 TRI and Nifty Smallcap 250 TRI
10-year rolling returns of Nifty Next 50 TRI, Nifty Midcap 150 TRI, and Nifty Smallcap 250 TRI

This trend is also observed in the US stock market. The 15-year rolling returns of S and P Smallcap 600 vs S and P Midcap 400 vs S and P 500 (large cap) is shown below. Since the total returns index history for the mid cap and small cap indices are short, we have taken the price indices and added a premium to correspond to dividends. These premiums are computed as the average return difference between total returns and price indices.

15 year rolling returns of S and P Smallcap 600 vs S and P Midcap 400 vs S and P 500
15-year rolling returns of S and P Smallcap 600 vs S and P Midcap 400 vs S and P 500

Aside from sporadic data points, the small-cap index has never outperformed the mid-cap index. The moral of the story is it is extremely unproductive to invest in a small cap index.

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But what about actively managed small cap funds? Surely they would easily beat the small cap index?

I am yet to explore the status of the US markets. At the time of writing, I could not find any free resources to do so.

We have repeatedly reported the status of the Indian markets:

Although most actively managed small cap funds outperform the small cap index, half or less than half the funds in the category can consistently beat the mid cap index.

If I were writing my PhD thesis, I would just compare active small cap funds with a small cap index and be done with it. I am doing something far more important. I am asking which investment gives the best value for my money.

Why should I pay an active small fund only for it to underperform a mid cap index when I can invest in the mid cap index at a much smaller fee or the Nifty Next 50 index?

Then there are arguments like X or Y small cap fund has done extremely well. These are subjective to at least two biases: survivorship and hindsight. We can’t randomly pick some funds to prove our opinions.

To make things worse, the Indian mutual fund industry is constantly evolving. Many of the small cap funds we see today started out as mid and small cap funds (HDFC Small Cap Fund). Some were closed-ended small cap funds converted to open-ended on maturity (Franklin Smaller Comp). We even have a bond fund that became a small cap fund (Quant Small Cap)!

Even for funds like Nippon India Small Cap, which was predominantly small cap since inception, the asset allocation rules changed due to the SEBI mutual fund categorization rules.

So we could argue that the small cap category is over five years old.  Using this fact, even if we discard the above-mentioned data, which is not in support of the “great small cap fund theory, we will have to accept there is not enough history to claim “A small cap mutual fund will beat all other categories (and indices) over the long term.”

Our recommendations:

Suppose you wish to invest in small cap funds: 

A mid cap 150 index is not a terrible idea, but we are still sceptical about these as the tracking errors are significant. See: Not all index funds are the same! Beyond the top 100 stocks, tracking errors are huge! The fund manager may struggle to keep pace with the index during market downturns due to liquidity constraints.

I would avoid factor indices based on quality, momentum, and value. For example, in 2022, NIFTY Midcap150 Quality 50 – TRI gave a minus 5.4 return. This was the 7th worst performer! Compare that with 5.45% for Nifty Midcap 150 – TRI. That is quite a gap! Investors must appreciate that the quality factor has an arbitrary definition and will be subject to poor sequences of returns from time to time.

Considering all these, we still prefer Nifty Next 50 for those who want to look beyond Nifty 50.

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