Motilal Oswal Nifty Smallcap 250 Index Fund: Will this make a difference?

Motilal Oswal Nifty Smallcap 250 Index Fund Review

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The third of the four new index funds from Motilal Oswal is one that will replicate and track the Nifty Smallcap 250 Index. Motilal Oswal Nifty Smallcap 250 Index Fund will be India’s 1st small cap fund. The Nifty Small Cap 250 index is the bottom half of the NIfty 500.  Let us find out if this worth investing in. We have already reviewed Motilal Oswal Nifty 500 Fund and Motilal Oswal Nifty Midcap 150 Index Fund.

Let us first consider this intuitively. The small cap space is not one where you “buy the market” because of higher failure rates. This is where active small cap funds state that small caps are “under-researched” and it is easier to construct a small cap portfolio better than the index.  Hence the question will Motilal Oswal Nifty Smallcap 250 Index Fund make a difference?

Nifty Smallcap 250 vs active small cap funds

So first, let us compare 12 active small cap funds with Nifty Smallcap 250 Index. If we demand our active small cap fund to beat the index at least 70% of every possible five year period, the number becomes 11. That is more than decent. Expect the same 70% outperformance in addition for four year periods, we get 10 funds. Again only a small drop.

Now demand at least 70% outperformance for three years also then it is still the same 10. So it should be clear that actively managed funds make a difference in the small cap segment. One argument is that many of these funds had a history of either small cap + mid cap funds or mid cap + small cap funds. This is a fair criticism.

The counter-argument to this is that many funds here continue to hold sizeable mid cap stocks often higher than that stipulated by SEBI (although that could be interpreted as an annual average). Thus active small cap fund managers tend to tactically increase mid cap allocation and help investors manage their emotions better.

This is clearly seen in the downside protection consistently. That is how often do funds fall less than the index when the index fall over a month. Remove the 70% return filers and the lowest downside protection consistency is 68%. This, of course, means practically all fund protect the investor from the big dips in the small cap index.

So in the light of this evidence, it is reasonably easy for an average investor to choose an active fund that is capable of outperforming the Motilal Oswal Nifty Smallcap 250 Index Fund on the basis of both risk and reward. If this situation changes in future, let us worry about it then.

I am not in favour of explicitly adding small cap exposure in a mutual fund portfolio. I think a decent mid cap fund would have all the small cap exposure that most investors need. The point I am trying to make here is: if you are interested in small cap stock exposure, then an active mutual fund is a better choice today than this new index fund. If the situation changes later, then we can change our stance. Not before.

Nifty Next 50 vs active small cap funds

Since we saw that Nifty Next 50 is a better index to invest in compared to Motilal Oswal Nifty Midcap 150 Index Fund, it is perhaps appropriate to find out how the small cap fund managers have fared against Nifty Next 50. We shall use the same return filters as mentioned above.

Five year: 70% + return outperformance: 11 (out of 12)

Add Four years: 11 becomes 6 (that is a big drop)

Add three years: It stays six. So at least half the small cap funds have trouble beating Nifty Next 50! Even if we consider only downside protection, only 8/12 funds cross the 70% filter. This is lower than for the Nifty Small Cap 250 Index. Thus having a Nifty Next 50 Index fund in suitable proportions is a better deal than holding an active small cap fund.

Nifty Smallcap 250 vs Nifty Next 50

Now let us compare returns of Nifty Smallcap 250 vs Nifty Next 50 (dividends included) over every possible ten and five year periods.  Notice that both the Nifty Next 50 and Nifty Midcap 150 Indices comfortably trump the Nifty Smallcap 250 Index.Nifty Smallcap 250 vs Nifty Next 50 vs Nifty Midcap 150 ten year rolling returns chartNifty Smallcap 250 vs Nifty Next 50 vs Nifty Midcap 150 five year rolling returns chart

Shown below is the rolling standard deviation (risk) graph for ten and five year periods. In this case, we consider how much a monthly return deviates from the average monthly return over a 5/10 year duration. This is a measure of risk. Higher the line, higher the risk.Nifty Smallcap 250 vs Nifty Next 50 vs Nifty Midcap 150 five year rolling risk or standard deviation chart

Notice that there is no particular benefit of holding a 250 stock index. The risk is comparable to the other two indices considered.

Motilal Oswal Nifty Smallcap 250 Index Fund: Should I invest?

A clear and vehement no. Active fund managers – by virtue of comfortably straying away from the small cap index – are able to beat the Nifty Smallcap 250 in terms of both risk and reward. Most importantly they provide downside protection which is most crucial while investing in the small cap space.

Yes, the cost of active fund management is high – probably the highest in this space, but that is a price to pay. One argument in favour of Motilal Oswal Nifty Smallcap 250 Index Fund is the following: Anyway I need to periodically (tactically) book profit and re-enter from a small cap fund to preserve gains, so might as well do it from a small cap index fund and lower costs.

This is a fair argument, but there are two aspects to be considered. (1) Investors do not typically walk the talk.  In fact, most investors who go on and on about passive investing do not have considerable exposure to index funds.

(2) Holding 250 small cap stocks can be a nightmare for the fund manager. An active fund manager sensing market trouble can move to large caps or mid caps (in fact many hold large cap stocks as a proxy for cash). A small cap index fund has no such luxury. The scheme document of Motilal Oswal Nifty Smallcap 250 Index Fund says it will hold 95% of the index at all time. This is quite dangerous if we have a huge crash like 2008.  Aside from the loss, there could be increasing in tracking error and significant deviation from the index.

As such I do not expect the AUM of this fund to be significant and even the normal tracking error would be higher than say a Nifty 50 index fund or ETF. Given all this, it simply does not make sense to buy this. Stay away and stick to Nifty 50 and Nifty Next 50 index funds if wish to be a passive investor in India. See Combine Nifty & Nifty Next 50 funds to create large, mid cap index portfolios

 

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4 Comments

  1. One point missed here is how will this fund offload stocks if there are no takers? If things turn worse, there could be 100 illiquid smallcap stocks thats not in the index but fund cannot find a buyer.

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