A small-cap mutual fund is by default, most often, the category with the highest returns, especially this year with a massive 51.8 per cent return.
Investors should not choose this category based on their returns alone, as you will see below, it is possible for this category to simply provide no returns for many years and the market regulator has recently asked them to do an internal stress test.
Small-cap mutual funds invest in small-cap companies that are currently going through a huge growth stage albeit with higher risk.
Small-cap mutual funds need to invest at least 65 per cent of their assets in small-cap stocks and the remaining 35 per cent can either be in cash or invested in large-cap stocks.
Small-cap stocks are argued to give a more accurate representation of the Indian economy with many emerging companies in this category. Large-cap indices, heavily tilted by a handful of stocks, are often argued to fail to provide a true picture.
The S&P BSE Small Cap index has surged by 64 per cent in one year, compared to the broader BSE Sensex, which saw an 18.5 per cent increase.
AMFI data shows 24 small-cap funds, collectively boasting an average return of 51.81 per cent over one year and 35.3 per cent over three years. The 1-year returns of funds range from 29.50 per cent to a whopping 73.16 per cent. Over the 3 years, returns from funds vary from 27.62 per cent to 50 per cent.
Bandhan Small Cap Fund showed consistently strong performance across all time frames, with the highest one-year return of 73.16 per cent and a decent 3-year return of 34.72 per cent. Quant Small Cap Fund exhibited strong returns across 1-year, 3-year, and 5-year periods with 69 per cent, 50 per cent (highest in category) and 38 per cent respectively.
Extended Period of Zero Returns Possible: You have read whopping returns from this category.
Now see that the same category gave only 28.13 per cent for 5 years, and 24.48 per cent for 10 years, and so it is evident that most of these funds have experienced extended periods of paltry or zero returns.
So if choosing a small-cap fund, commit to a longer time horizon of at least 5 years and be prepared for volatility.
Sebi has recently asked small-cap mutual funds to do an internal stress test to see if they could withstand potential sharp market falls or sudden outflows, anonymous sources told Business Standard this week. This is a rare move and it comes amid concerns about heavy inflows elevating stock prices and increasing the risk of a significant correction.
Huge returns from small-cap funds are driving a substantial upsurge in contributions to small-cap mutual funds observed recently. According to Value Research, small-cap mutual funds saw inflows of Rs 4,328 crore in 2023, more than double the previous year. This causes the risk of some stocks getting overvalued causing a correction.
One such correction happened in October 2023 but Kotak Institutional Equities said that the correction was minimal and more correction can be expected ahead.