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What’s all the fuss about small cap funds?

Across print and digital media, there is a lot of analysis around small cap funds and how some of them have exceeded return expectations in the last one year. Find out what's the reality.

Across print and digital media, there is a lot of analysis around small cap funds and how some of them have exceeded return expectations in the last one year. 

If you haven’t heard yet, here is a sample: the headlines show that while Axis Small Cap fund delivered a return of around 37% in the last one year, its lagging counterpart HDFC Small Cap fund delivered -1%. 

Reading this can evoke two reactions; you are likely to think that the second fund is a huge underperformer and you will feel left out if you haven’t invested in the first one. However, this is at best a distortion of reality, by presenting limited information. 

One-year returns are incomplete

Here is a sample of how small cap funds have done in the last 10 calendar years. For the sake of simplicity, only funds with a performance history of five years or more have been shown. 

Clearly 2019 was a good year for Axis Small Cap fund and in 2018 as well, the fund did relatively better than most others, but for four years before that from 2014 till 2017, the fund was not in the top 5 performers within the category. HDFC Small Cap which sits almost at the bottom in 2019, was among the top 5 performers in 2018 and 2017, it has fallen below median or middle of the category performance in four out of the last 10 years. So, not really that poor a fund. 
 
While this example only talks about the two schemes, you can see clearly from the table that there is no one fund that remains on the top or even in the top quarter of the performance chart year after year.
 
This kind of volatility can cause a lot of anxiety and what you need to be aware of is a metric called standard deviation. This is published for all schemes and shows you the extent to which returns can move away from the average return delivered by the scheme over a given period of time. The higher it is, the more volatile the scheme is likely to be. For example, small cap schemes as a category have an annual standard deviation of more than 17% against 12% for large cap funds. 
 
Looking only at returns is incomplete
 
Another glaring aspect of small cap funds which gets revealed in the table is the spread of returns each year. Axis Small cap itself has gone from delivering a -9% in 2018 to almost 20% in 2019 – that’s a difference of 29% in annual performance! 
 
This kind of volatility can cause a lot of anxiety and what you need to be aware of is a metric called standard deviation. This is published for all schemes and shows you the extent to which returns can move away from the average return delivered by the scheme over a given period of time. The higher it is, the more volatile the scheme is likely to be. For example, small cap schemes as a category have an annual standard deviation of more than 17% against 12% for large cap funds. 
 
Highly volatile returns can adversely impact your return expectation at the time of redemption. 
 
Long term returns in small caps
 
Here is another part of the picture which is missing. If you consider the ten-year performance of small cap funds, the median or middle of the category performance is about 12% annualised return, with the highest at 19% and lowest at 8% annualised return. This compares to a median performance of around 10.5% in the large cap category, with the highest at around 15% and lowest at 7.5% annualised return.
The performance details for the large and mid-cap category are pretty much the same as the small cap category. 
 
However, both the large cap and large and mid-cap category come with a much lower volatility in return. What this means is that you can achieve a similar long-term return objective from funds in the two categories mentioned above as you can with small cap funds but with a greater certainty of achieving your return expectation at the end of your horizon.
 
Next time you see a tempting return comparison, don’t get carried away by the extreme picture. Look for long term comparisons and the inclusion of risk in a return picture. Certain small cap funds may look very tempting now, but the result can alter dramatically next year; Unless you are able to time the entry and exit to perfection, ask yourself if you really need that kind of volatility in your portfolio.
 

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