Best Small Cap Mutual Funds to Invest in 2018

Smallcap stocks may be down and out, but many investors are still crazy about smallcap mutual funds. We get queries from our readers everyday, asking us about recommended schemes. That is why we decided to come up with a small list of smallcap schemes for our readers. The re-categorisation of mutual fund schemes by Sebi presented the right opportunity. So, here we are with our first-ever recommendation of smallcap mutual fund schemes.

Before proceeding to the list and methodology, here are a few important things. One, do not chase returns and invest in smallcap schemes. As you know, smallcap schemes invest in smallcap stocks or stocks that are ranked below 250 in the stock exchange in terms of market capitalisation.

According to the new Sebi guidelines, smallcap universe starts from the 251st company. The top 100 companies in terms of market capitalisation fall under the largecap segment. The next 101st- 250th companies will be midcap companies. Earlier, different fund houses had different mandates for picking up stocks under different market capitalisations.

That brings us to the second important point: Smallcap stocks/schemes are risky and they can be highly volatile. That is their nature. You simply can’t do anything about it. A small stock gets hit badly during a market meltdown. A larger stock may come relatively unscathed, but small stocks invariably pay a heavy price for every negative news in the market. So, invest in them only if you have the stomach for volatility and risk.

Smallcap schemes bet on small companies with high growth potential. These schemes can give you higher returns but they are more vulnerable to any negative market movement than large- and mid-caps. If these bets realise their potential, they may reward investors handsomely. After Sebi’s re-categorisation of mutual funds, smallcap schemes are mandated to invest minimum 65 per cent of its assets in smallcap companies.

Three, the only way to tackle the risk and volatility is to remain invested for a long period. Though, most mutual fund advisors typically ask investors to go for equity schemes with an investment horizon of five to seven years, we believe that investors should invest in smallcap stocks with a longer investment horizon. We would recommend investing in smallcap schemes with a horizon of at least seven to 10 years.

Remember, smallcap schemes are risky and volatile, but they also have the potential to offer higher returns over a long period. For example, the smallcap category has offered 16.78 per cent in the last three years, 29.81 per cent in five years, and 15.96 per cent in ten years.

Finally, if you have a long-term investment horizon and a high risk appetite, you can invest in smallcap schemes to earn higher returns. Here are our handpicked four smallcap schemes for you.

september 2018

Our methodology: Mutual Funds has employed the following parameters for shortlisting the mutual fund schemes.

1. Mean rolling returns : rolled daily for the last three years.

2. Consistency in the last three years : The three-year period is divided into smaller time periods each with a progressing weighting.

3. Downside risk : We have considered only the negative returns given by the mutual fund scheme for this.

X =Returns below zero

Y = Sum of all squares of X

Z = Y/number of days taken for computing the ratio

Downside risk = Square root of Z

4. Outperformance: It is measured by Jensen’s Alpha for the last three years. Jensen’s Alpha shows the risk-adjusted return generated by a mutual fund scheme relative to the expected market return predicted by the Capital Asset Pricing Model (CAPM). Higher Alpha indicates that the portfolio performance has outstripped the returns predicted by the market.

Average returns generated by the MF Scheme – [Risk Free Rate + Beta of the MF Scheme * {(Average return of the index – Risk Free Rate}

5. Asset size: For equity diversified funds, the threshold asset size is Rs 100 crore, and Rs 50 crore for balanced funds.

We have also conducted a back testing of our model portfolios. These returns are forward returns from the base date.

(Disclaimer: past performance is no guarantee for future performance.)

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