Why are you comparing Small Cap Mutual Funds with a Mid Cap Index?!

Published on / By M. Pattabiraman Twitter: @pattufreefincal

Published: January 5, 2023 at 6:00 am

A reader asks, “I recently used your equity mutual fund screener, and it is probably the best tool available for selecting consistent performers. You are comparing Small cap mutual funds with Nifty Midcap 150 TRI. Can you please explain why you do this?”

Suppose the Indian Cricket team has played 15 matches in about half a year, all formats included. They won all of them. Say, no other team has done it before. Would that make the Indian team the greatest of all time?

Not quite. We need to stop and look at who their opponents were. If, say, 70% of the opposition were non-test playing teams, would you still feel that the Indian team is the best, or would you feel the real test again the “main teams” is still to come?

The situation with small cap funds is quite similar. Actively managed small cap mutual funds are among the most expensive funds in the market. Most of them do manage to beat a small cap index more often than not. But that is like scoring centuries only against minnows and claiming I am the best in the business.

To appreciate what I mean, let us compare the rolling returns of Nifty Smallcap 250 TRI with Nifty Midcap 150TRI, Nifty Midcap 150 Quality 50 TRI and Nifty Next 50 TRI. We now have index funds available with all indices.

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Five years

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

Ten years

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

Fifteen years

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

Notice that Nifty Smallcap 250 TRI has always come last! Even if we recognise that the history over 10 and 15 years is short, it is hard to place any money on the small cap index.

Therefore it is not much of a victory for active small cap funds to beat a back-bencher. Why pay so much when there are less expensive options like Nifty Next 50, Midcap Quality 50, or even Midcap 150 (tracking error notwithstanding)? This is why we insist on comparing small caps funds with Nifty Midcap 150 and Nifty Next 50.

The bad news is most small cap funds do not fare well against these indices!

So our recommendation is to avoid Small cap mutual funds, especially SIPs. If you cannot stay away from them, consider a tactical approach: Do not use SIPs for Small Cap Mutual Funds: Try this instead!