Top small cap mutual funds turn Rs 10,000 per month into Rs 55.8 lakh in 10 years; is it time to invest in small cap funds? So, is it time to shed the risk aversion associated with small caps and make these the crown jewels of your portfolios?
With small-cap funds scorching the performance charts, these have become the flavour of the season. Investors are piling on, with expectations of continued momentum in returns. They are being told that they simply cannot ignore small-cap funds if they want serious wealth creation. So, is it time to shed the risk aversion associated with small caps and make these the crown jewels of your portfolios? The numbers do look mouth-watering. Over the past three years, small-cap funds have clocked an annualised return of 39.4%, compared to flexi-cap funds’ 22.4%, and mid-cap funds’ 31.1%. This gap in return translates into a big gulf in corpus. If you stretch the horizon over 10 years, the difference is acute.With a Rs 10,000 monthly SIP over the past 10 years, your investment of Rs 12 lakh in a small-cap fund would have surged to a whopping Rs 41.24 lakh. Comparatively, a mid-cap fund would have grown the pot to Rs 34 lakh and the flexi-cap scheme to Rs 28 lakh. The top performing small-cap fund generated Rs 55.8 lakh. Meanwhile, the best mid-cap and flexi-cap funds fetched Rs 41.2 lakh and Rs 36.43 lakh, respectively. If you were to go by these figures, shying away from small-cap funds would imply missing out on a bigger corpus. At least, that is the argument being offered on social media.
Many investors avoid small-cap funds for the perceived risks, since the returns tend to exhibit higher volatility. Over three-year time frames in the past six years, flexi-cap funds have seen a standard deviation of 6.37%. For mid-cap funds, it is 9.26%, and for small-cap funds, the standard deviation is 13.69%. Higher standard deviation by itself need not be a deal-breaker. It signifies that the small-cap fund’s return tends to be more widely dispersed around its mean. It can be argued that if the mean return itself is often (but not always) higher for small-cap funds, the wider dispersion holds little significance. Perhaps some volatility is a price worth paying for the return potential. However, we should dig a little deeper.
We know that small-cap funds are particularly vulnerable in a falling market. This can be measured by the drawdown—the extent of erosion in a fund’s NAV during a market fall. Drawdowns in small-cap funds are evidently more acute. Over five years, the maximum drawdown in small cap funds averages -40%, as per the data from Morningstar. For mid-cap and flexi-cap funds, it’s -33.6% and -32.6%, respectively. Over 10 years, the gap is even bigger. What’s more telling is the duration of drawdown and the subsequent recovery.
Many small-cap funds are not only guilty of experiencing protracted drawdowns, but they also take longer to recover lost value. Morningstar data shows that over a 10-year time span, small-cap funds have taken roughly 152 weeks to recover value from the worst drawdown (covering peak trough-peak date). Comparatively, midcap funds have taken 116 weeks and flexi-cap funds 65 weeks. Why is this critical? Perhaps you can stomach a gut-churning drawdown of -40% if it lasts 3-6 months and rebounds within a year, but would you be comfortable if this timeline stretches over 24-30 months, or longer?
This is not a game everyone can play. For many investors, sharp, long-lasting drawdowns are unnerving. When faced with such a scenario, the tendency is to seek the exit door. If your investment simply won’t let you stay in the game, it will be a bigger loss than the additional gains you potentially forfeit by avoiding this space. If your risk appetite allows you to digest the upheavals in flexi-cap or mid-cap funds, and gives you the strength to stay invested for longer, you are better off playing within that comfort zone. Don’t get swayed by the promise of higher returns. Your investing success is not merely a function of returns. What matters more is your ability to ride the market’s turbulences without interrupting the compounding process.
Let’s assume that you can comfortably absorb this elevated risk. Isn’t it worth the pain if there is a bigger pot of gold assured at the end? That seems to be the case considering today. Now let’s rewind to March 2020. Small-cap funds were sitting on a 10-year return of 7.5%, lower than mid-cap funds’ 8.8% and only marginally higher than flexi-cap funds’ 6%. Perhaps we are nitpicking. So, let’s cast a wider net. Over seven-year time spans since 31 July 2010, the worst return an average mid-cap and flexi-cap fund has managed is 4.75% and 0.95%, respectively. Meanwhile, the average small-cap fund suffered a loss of -2.84% in its worst phase. The risks in small caps will always be present. And don’t always count on that pot of gold.
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This story originally appeared on: India Times - Author:Faqs of Insurances
