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What are small-cap mutual funds? A guide about how they work in India

A company’s value is determined by its market capitalization which is nothing but the market value of its shares 

In India, companies having a market capitalization of less than Rs. 500 cr. is classified as a small-cap company. This article is a detailed guideline on small-cap mutual funds.

Small Cap Mutual Funds

What are small-cap mutual funds?

As a general practice, one must conduct thorough research into the companies, the mutual funds will be investing in. A few basic things like the business model, profitability, debt etc. goes a long way in understanding the company. 

Small companies can grow beyond anyone’s expectations and can give better returns over a short period. This also means that such stocks would be subjected to high volatility as well.

The identification of the companies who have the potential to grow would go a long way in forming part of the best small-cap funds to be invested in.

Who should invest in small-cap mutual funds?

Small-cap funds carry high market risk as compared to large-cap or mid-cap funds. An investor should be well aware of their risk appetite and their ability to absorb higher risks. Small-cap funds are those investors who have an investment horizon over 5 years and are willing to take some risk. These funds have delivered higher returns compared to their benchmark.

Points to consider before investing in small-cap mutual funds

Small-cap mutual funds are considered riskier as compared to other categories of funds. Before investing in small-cap funds, you need to consider the purpose of the investment(child’s education, retirement planning), investment horizon, your understanding of how much risk you can take etc. You can also consider the below points as a part of evaluating the small-cap funds:

Sectoral Balances

Ideally, investments should be made in those small-cap funds that invest across sectors. This, in turn, will help in diversifying your portfolio in terms of risk and returns. 

It’s better to avoid those small-cap funds that invest only in selective stocks. The chances of better returns are higher in case the companies show exceptional performance but its riskier as de-growth would wipe off the better parts of the returns.

P/E Ratio

P/E ratio is used to identify the risk level at which the mutual funds operate. In mutual funds, this is nothing but the average PE of the stocks that constitute the fund’s portfolio. 

If the PE of the portfolio is high, it means that the fund is paying for premium for the growth of the portfolio companies.

On the other hand, if the PE is low, it means the fund manager is following a safer approach in terms of stock selection.

Fund Manager

One should have an idea about the fund manager handling the fund. His track record, past experiences will give investors confidence and help in better selection of the small-cap funds.

Historical Performance

This is a very important aspect. One should not rely on just the recent performance of the funds in terms of returns. In order to the same, returns of the past 5 years or above should be taken as a base and the same should be compared with peer funds. 

Depending on the market conditions, if the fund has performed consistently, then it can be considered as a good fund to invest in.

Holding pattern

It is important to know where the largest investment has been made by the fund manager. This would help in keeping a close track of the company and related important information.

How to evaluate small-cap mutual funds?

Sharpe Ratio

Sharpe ratio is considered as a very popular method for measuring risk-adjusted returns.

Sharpe ratio = (return on investment – risk-free return)/standard deviation of the investment

The higher the Sharpe ratio, the better it is because the portfolio has given much better returns compared to the risk. In simple terms, it shows how well the returns of the asset has compensated for the risk taken.

Treynor Ratio

The Treynor ratio measures the excess return earned above the risk-free investment. It determines how much excess return was generated for each unit of risk taken by the portfolio.

Treynor Ratio = (return of the portfolio – risk-free return)/beta of the portfolio

The Sharpe ratio helps investors understand an investment‘s return compared to its risk while the Treynor ratio explores the excess return generated for each unit of risk in a portfolio.

Jensen Alpha

Simply put, Jensen alpha is the difference between the actual return earned vs the overall benchmark return. It measures the ability of the fund manager to increase the returns above the benchmark. It is considered useful only when comparing 2 portfolios with the same beta.

Published on January 20, 2020