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There is a saying often repeated in the stock market – ‘If there is risk, there is love’ or in other words, ‘If there is risk, there is return’. In the world of mutual funds, this most accurately applies to the small cap category. The track record of the last decade shows that small cap funds have created windfall wealth for investors who have remained patient through periods of huge market volatility, decline and uncertainty. Even though the shares of small cap companies fall faster during recession compared to large cap and mid cap, but when the country’s economy picks up pace, these small companies grow rapidly and become multibaggers. On the basis of continuously increasing participation of retail investors in the Indian domestic market and Systematic Investment Plan i.e. SIP, small cap funds have recorded compound annual returns (CAGR) of 20 to 23 percent in 10 years.
According to the classification of Securities and Exchange Board of India i.e. SEBI, companies listed in the stock market are divided into three main categories on the basis of market capitalization. Companies from 1st to 100th position are considered as large cap, companies from 101 to 250th position are considered as mid cap and all the companies below 251st position are considered as small cap. Under the mandatory rules of SEBI, any small cap mutual fund has to invest at least 65 percent of its total assets in the shares of these 251st ranked companies. Small companies have the potential to grow rapidly, but they also face serious risks of cash crunch, sector downturn or liquidity issues. This is the reason why when the market falls, small cap funds see a greater decline than large cap funds. However, in the long run, companies with the right business model register multifold growth, giving investors extraordinary benefits of compounding.
Nippon India Small Cap Fund has proven to be the largest and most consistently performing fund in the category. The Direct Plan of this fund has given annual compounded returns of around 22.5 to 22.8 percent in the last 10 years. The asset under management (AUM) of this fund has crossed Rs 80 thousand crore and has made diversified investments in hundreds of emerging companies. At second place comes Quant Small Cap Fund, which has given CAGR returns of about 20.2 to 20.5 percent in 10 years through its dynamic and quantitative momentum model. At the third place comes the name of Axis Small Cap Fund, which has registered an excellent 10-year return of about 20.2 percent. Axis’ focus has always been on selecting businesses with low volatility and strong fundamentals. SBI Small Cap Fund is in fourth place, whose 10 year annual return has been around 20.18 percent. At fifth position comes HDFC Small Cap Fund, which has delivered 10-year annualized returns of over 19.5 percent to its investors.
To understand the power of compounding, if an investor had started a SIP of Rs 10,000 per month in a top small cap fund 10 years ago, the mathematics would have been shocking. The total principal amount deposited by the investor in 10 years would have been Rs 12,00,000. At an average CAGR of 21 to 22 percent, this capital of Rs 12 lakh would have grown into a huge corpus of Rs 38 lakh to Rs 44 lakh within 10 years. Whereas if someone had invested a lump sum amount of Rs 1 lakh in a fund like Nippon India Small Cap 10 years ago, that amount would have grown to more than Rs 7 lakh today at a compound growth rate of more than 22%. It is this financial strength that attracts small investors towards small caps in the journey of wealth creation.
Investing all the money in small caps without thinking after seeing the bright returns can be very harmful from the financial point of view. This category is not at all for those investors who want to invest money for less than 1 to 3 years or who get nervous seeing a 20 to 30 percent decline in their portfolio. While investing in small caps, it is essential to have a vision of at least 7 to 10 years. Apart from this, it is also very important to take care of valuation. When the market is at its all-time high, one should avoid investing huge lump sums as small caps may take a long time to recover during any correction.
According to financial experts, to create a balanced portfolio, only 15 to 25 percent of your total equity investment should be allocated to small cap funds. The remaining capital should be placed in large cap, flexi cap and debt funds so that the overall portfolio remains stable. Apart from this, the safest and most effective way to enter small caps is Systematic Investment Plan (SIP) or Systematic Transfer Plan (STP). Investing through SIP gives you the benefit of rupee cost averaging, which means you will get more units when the market falls and your total portfolio will earn faster profits when the market rises. Long term discipline, regular review and correct asset allocation is the most effective mantra to achieve financial freedom through small caps.