Why your small cap mutual fund must beat this benchmark!

Last Updated on December 29, 2021 at 4:55 pm

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

Notice 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:

Amusingly 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

Rolling return performance seven years

Rolling return performance five years

Rolling return performance three years

Summary

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.