Divergence in small cap mutual funds' returns at 2-decade high

Picking the right smallcap mutual fund scheme has become a challenge for investors. In the past one year, there have been stark contrasts in the performances of schemes within the smallcap category. The best performer in the space, Axis Small Cap Fund, returned 37.37 per cent in a year, while HDFC Small Cap, which shed 1 per cent in value, has been a notable laggard. Analysts said this polarisation in returns is the highest they have seen in the last 20 years.

Data from Value Research showed that the average returns from the small-cap fund category have been 12.34 per cent in the past one year. The S&P BSE SmallCap Index has moved up by 10.3 per cent. Usually, returns from most funds are around the category average with just a handful of them outperforming or lagging behind in a big way. But the extent of outperformance and underperformance has been extreme given that small-cap stocks have been languishing since January 2018.

Most top performers among small-cap funds have returned 22-26 per cent on an average, while the laggards have delivered 2-6 per cent. So, what is it that the winners have done right in this phase? Analysts said higher cash in portfolio, more churn and lower assets under management along with the right stock bets have helped better performance.

“Those who took early cash calls survived the brunt. While Axis Small Cap had 77 per cent in equities in January 2019, HDFC Small was at 87 per cent,” said Vidya Bala, founder, Prime Investor. The portfolio turnover in Axis has been higher, suggesting deft calls, while in HDFC, the churn was extremely low, she said.

Axis Small Cap fund held 11.1 per cent cash in its portfolio as of January 2020. Some of the stocks it held such as NIIT Technology, MAS Financial and Fine Organics have doubled in the last couple of years.

The stricter recategorisation of stocks as per their market capitalisation last year hurt returns of various small-cap funds, which are allowed to hold fewer bluechips in their portfolio. Some existing small-cap funds, which earlier had a higher proportion of larger stocks by market capitalisation, sold some of them after the recategorisation, weighing down their performances.

Some small-cap funds used a strategy of holding large-cap defensives to beat a falling market. As per the Securities and Exchange Board of India’s definition, a small-cap fund needs to hold a minimum of 65 per cent in smallcap stocks that rank 251st onwards in market capitalisation.

The balance 35 per cent can be held in large and mid-cap stocks as per the discretion of the fund manager.

“Some small-cap funds held largecap stocks to meet liquidity requirement in their portfolio. These stocks did not perform well in the last one year that hurt returns,” says Rupesh Bhansali, head (distribution), GEPL Capital.

Large asset sizes are turning out to be a challenge for many of the funds, which saw huge inflows in 2018 and 2019 post the rally in 2016-17. “Size is a challenge and many funds limit inflows and that is a good thing in this market-cap segment,” says Vidya Bala. SBI Small Cap and DSP Small cap do not accept lump sum investments and accept money only through SIP route, as that prevents big flows into the fund.

Fund managers have been recommending small-cap funds as valuations are attractive. The price to earnings (PE) ratio of S&P BSE 250 Small cap has fallen from 100.32 in January 2018 to 37.62 in February 2020. The share of smallcaps in the overall market cap is down to 10.6 per cent, the lowest in the last five years, while the SmallCap index is trading at a discount of 34 per cent to its large-cap counterparts as against an average discount of 15 per cent.