• HDFC
• 26 Jun 2018
• MF Product

HDFC, Tester

One of the golden rules of investing is that risk and reward are directly proportional. Higher the risk, higher the likely returns. Lower the risk, lower the returns. This holds true for small-cap mutual funds, which come with high risk but hold the potential for great returns

What are small-cap mutual funds?

SEBI categorizes companies that are not in the top 250 shares in terms of market cap as small caps. The top 100 are large caps. Midcaps are those ranked 101 to 250. The rest are small caps.

Are small-cap mutual funds a good bet? Who should invest in small caps and why?

If you have a good appetite for risk and are looking for higher returns, then you can add small-cap funds to your portfolio.

The pros of small-cap mutual funds:

• Returns: The star stocks of the future are often to be found among the small caps. Small caps are typically those whose potential has not yet been fully discounted by the market. A good small-cap mutual fund focuses on discovering stocks that offer hidden value.

• Diversification: The small-cap universe is a large one and offers a huge diversity of choice for picking stocks across sectors and industries. Mutual fund managers can identify and pick niche companies that could be potential multi-baggers.

The cons of small-cap mutual funds:

• Risk: Small caps are highly volatile and swing much more than midcaps and large caps when markets are unpredictable. Many of them are illiquid and, as a result, may not offer good exits in falling markets. Therefore, small-cap mutual funds may be suited only for investors with a good risk appetite.

• Fund-dependent: Picking good small caps requires a lot of research and analysis. Not all mutual fund managers may be able to do this successfully. So, the success of a small-cap fund rests heavily on the capabilities of its fund manager and her team.

Performance: Small caps vs the rest

You can get a good idea of how small caps perform by comparing their returns to those of midcaps and large caps.

• The small-cap index (Nifty SML 100) gave year-to-date returns (on March 31, 2018) of -14%. The same index gave a two-year return of 63%
• The midcap index (Nifty Mid 100) gave YTD returns of -11% and two-year returns of 52%
• The Nifty 100 (large caps) gave YTD returns of -4% and two-year returns of 36%

It’s clear from this that when the markets rise, small caps do better than their midcap or large-cap peers, but when markets turn volatile small caps perform badly.

If you plan to invest in a small-cap mutual fund, take a longer-term horizon and give time to the fund to navigate short-term volatility.