Is Investing in Small Cap Funds Really Risky?

Many investors confuse small value stocks with small cap stocks. They simply assume that stocks with low prices are small cap stocks. But that’s not true.

Stocks are classified according to their market cap into three categories, namely large cap, mid cap & small cap. The definition of all three market cap categories can vary among different fund houses, brokerages, etc. However, for mutual funds, in order to ensure uniformity, SEBI has defined the criteria for classifying stocks as large, mid and small cap. As per SEBI’s categorization, based on their average market capitalization, the first 100 companies are defined as a large cap (rank 1 – 100) and the next 150 companies are classified as mid cap (rank 101 – 250), the rank of small cap stocks start from 251 onwards. Small cap funds, as per SEBI’s definition, are those funds which have at least 65% of their holding in small cap companies. Depending on the view of the fund manager, the remaining portfolio can be invested in large, mid or small cap companies or in debt.

Now, those who invest in small caps should be ready to take on added risk in exchange for potential higher returns. Some of the risks that small cap stocks present are lack of liquidity due to low trading volume, the higher probability that a company will close down in case of a slowdown, less access to large financing resources for capital and non-availability of enough information in the public domain about the management and past performance of the company.

Nevertheless, while small cap stocks do come with some risk, it does not mean that investors should avoid investing in them. Rather, smaller sized companies can give you higher than expected returns. In order to minimize the risk by directly investing in such stocks, it would be best if we take exposure to smaller size companies by investing in small cap mutual funds. This will not only help in reducing the risk because of diversification but also one can get exposure to a larger number of small cap stocks with a limited investment amount. As per the latest data available with us, the average holding of smaller size companies in small cap funds is 60 companies.

There are many other reasons to invest in this category of funds and few of them are specified below:

Small cap funds do not invest their entire corpus in small cap stocks. They also have exposure to large & mid cap stocks, debt and cash, which acts as a cushion for liquidity. The table below shows that the average exposure to large & mid cap companies is 21%as on 30^th April 2019.

There are a total of 4,645 small cap stocks as per AMFI’s list of market capitalization (December 2018). The riskiness of stock may increase as the rank decreases. A look at the portfolio of small cap funds, as of 30^th April 2019, reveals that the smallest company that mutual funds have invested in, in terms of market cap, has a rank of 1170 and has an average market capitalization of approximately 337 crores. So, it’s clear that mutual funds have not invested in stocks that are below a certain size and rank.

Despite that, small cap funds have invested in barely 1.57% of the total small cap stock universe (considering only stocks with a market cap of above Rs. 100 crores) which was valued at approximately Rs.19.5 lac crores at end April 2019. This suggests that there is still scope for small cap funds to increase their exposure in the small cap space.

One important factor to consider while investing in small caps is the tenure of investment. The table below shows the daily rolling returns given by HDFC Small Cap fund since inception –

As we can see from the above table, the scheme has given negative returns for shorter tenures of 1 year and 3 years. As the holding period of the scheme increased, the scheme gave double-digit returns for a tenure of 7 years. This shows that one needs to have patience while investing in small caps as the longer the tenure, the better could be the returns. However, one will also need to brace for volatility.

Small cap mutual fund schemes should be selected by those investors who have a healthy risk appetite and an investment horizon of more than 7 years.

(Note: In the above article, Small cap funds with AUM above Rs. 100 crores only are considered)

Also Read: Why does RBL Bank look attractive to investors?

Disclaimer:

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company.

We do not individually or collectively hold 1% or more of the securities of the company.

We do not have any other material conflict of interest in the company.

We do not act as a market maker in securities of the company.

We do not have any directorships or other material relationships with the company.

We do not have any personal interests in the securities of the company.

We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships.

We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.