Why your small cap mutual fund must beat this benchmark!

Published: July 30, 2019 at 10:54 am

Last Updated on

Small cap mutual funds are weird creatures. They would offer spectacular happiness followed by an equal amount of sorrow in quick time. This is the reason I prefer a mid cap fund with a right amount of periodic (or systematic, all-time) small cap stock exposure. Since many investors, especially those who like to invest based on short-term performance, prefer small cap mutual funds, I think an appropriate benchmark is necessary for judging their performance.

This week, we will consider small cap performance in a few posts. The small cap stock universe is at least 2.5 times bigger than the large cap universe (top 100 stocks by market cap) if we restrict ourselves to Nifty 500.  Every small cap fund presentation would make sure to point out that small cap stocks are “underresearched” compared to large caps.

This essentially means a small cap fund manager can beat a small cap index with better ease than a large cap fund manager. I agree. However, active small cap fund selection must also ensure protection against market falls (downside). The simplest way to do this is to tactically increase or decrease mid cap (or large cap) exposure or behave like a small capish multicap fund at all times.

As shown in this study, Strange, but true! How mutual funds beat the index, downside protection is critical for return outperformance. Therefore I would prefer to judge a small cap fund with a small cap + mid cap index than a pure small cap index. The reason is quite simple: a midsmallcap index would fall less than a small cap index so that we can test fund outperformance during market downtime better. After all, a small cap fund limits losses will provide better sleep to its unitholders.

We have earlier dispelled the myth that small cap (or mid cap) stock exposure is better than large cap exposure “over the long term”: Large Cap vs Mid Cap vs Small Cap Funds: Which is better for long term investing?

I hope the results presented here will also reiterate the fact that mid cap exposure alone is enough, and exclusive small cap exposure is too risky to warrant consideration.

Nifty Small Cap 250 Index TRI This consists of 250 small cap stocks or the bottom half of Nifty 500.

Nifty Mid Cap 150 Index TRI This has 150 mid cap stocks excluding the top 100 large cap stocks from Nifty 100, and the bottom 250

Nifty MidSmallcap 400 Index TRI This is a mix of the above two indices or in other words, Nifty 500 – Nifty 100. This is also a capitalisation-weighted index unlike NIfty LargeMidcap 250 which has 50% of Nifty 100 and 50% of Nifty Midcap 150.

Nifty Small Cap 250 Index TRI vs Nifty Mid Cap 150 Index TRI vs Nifty MidSmallcap 400 Index TRI Price Variation

Nifty Midsmallcap 400 index vs Nifty Midcap 150 Index vs Nifty Smallcap 250 Index price movementNotice how much the smallcap index fell from Jan 2018. Comparing active small cap fund performance with a MidSmallCap index will tell us how good the fund is in managing risk (and reward too, see below).

The natural question to first ask is since the Nifty MidSmall cap index is not a blended index, how would it fare against a 50% Midcap and 50% Smallcap blend. You can create your blend indices via this simple method:

index with 50 percent midcap and 50 smallcapsAmusingly the 50:50 Mid: Small cap blend is identical to Nifty MidSmallcap, so the latter is good enough for comparison.

Now let us compare returns over every possible 10, 7, 5 and three years.

Rolling return performance for ten years

Nifty Midsmallcap 400 index vs Nifty Midcap 150 Index vs Nifty Smallcap 250 Index 10 year rolling returns data

Rolling return performance seven years

Nifty Midsmallcap 400 index vs Nifty Midcap 150 Index vs Nifty Smallcap 250 Index 7 year rolling returns data

Rolling return performance five years

Nifty Midsmallcap 400 index vs Nifty Midcap 150 Index vs Nifty Smallcap 250 Index 5 year rolling returns data

Rolling return performance three years

Nifty Midsmallcap 400 index vs Nifty Midcap 150 Index vs Nifty Smallcap 250 Index 3 year rolling returns data


Did you notice that the Smallcap index pretty much underperforms the Midsmallcap and Midcap index most of the time over 10,7,5 years? Over three years, it is closer, but during falls, the smallcap index underperforms. So what?

As an investor (if I held small cap funds) I expect my small cap fund manager to beat the Nifty Midcap 150 Index consistently. I would sleep better if my smallcap fund fell lower than a mid cap index. That is why I am paying management fees.

As an analyst, I expect the small cap fund manager to at least consistently beat the Nifty Midsmallcap index as this provides better downside protection than the smallcap index.

All that is fine, you say? Please show me the list of small cap funds that have performed well against the Midcap and Smallmidcap indices. I will, in the next part of this post.

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps