“Good things come in small packages” A proverb people love to apply in the investing domain quite often to justify their exposure to funds investing in small cap category. In last few weeks, I saw the portfolio of lot of people & found it disturbing that they have the large exposures to small or small & mid cap funds. Often you will find, people advising that small cap funds are more risky but this advise always fall on the deaf ears. As a result when the tide turns, people start running for shelter. Today we will try to understand that are small cap funds risky, should we own them if yes, how much exposure and which funds.
Myth : High risk means high returns
Most of the people correlate the relation of high risk to high return. They also went on to justify that their higher risk appetite and longer investment horizon allows them to take higher exposure to small cap funds. In 2017 small cap fund category delivered 46% returns, lot of newbies quickly turned their attention to this category and looked for 5 year returns. Fortunately there was no instance of -ve returns in 2013-2017 and CAGR of the fund category was 24%. This is awesome, no? This is a bias people have, come what may, most of us look at the recent data (specially returns) and place lot of importance on that vs Overall history. if you look in the below table you will realize that over a longer time horizon 2008-YTD the CAGR returns of this fund category has been mere 8.8%.
This might come as a surprise to many as 1. No one bothered to look for long term history/ 2. People think that this time it is different and Small caps will keep outperforming/ 3. They believe that they have skills to buy and sell at right time to avoid the years like 2008 or 2011 but fail to do so in 2018 even when there were signs of over valuations in that market segment.
Am i suggesting that we should not buy the small cap funds?
No, I am saying when you think that your risk appetite as well as risk capacity is higher than do not jump into small cap funds but increase your exposure to equity. In any portfolio, your aim should be to to keep the right amount of equity exposure. The Core Portfolio should always have a balance of debt and Large cap funds (Active or Index) then you can have satellite portfolio of small exposure (5%-15%) to Small cap funds or Sector/ thematic funds. You can read in detail at Core & Satellite investing.
Which small cap fund should you invest in?
I generally follow the below metric to select a fund, you can refer to the same. The fund has to have lower expense, better Alpha and Sharp ratios, Most importantly it’s max draw down should be limited. Based on these parameters, SBI Small Cap or HDFC Small Cap fund will be my preference but any Top 5 funds are good enough to be in your portfolio.
Lastly make sure, you review the fund performance every year and continue to watch them, exit if it goes outside top 5 and stays there for 6-12 months.