only the patient find alpha in small-cap funds

passive investing has dominated actively managed funds for years in developed markets and the trend seems to be catching up in India as well, especially in the large-cap equity segment.

data from S&P Indices versus Active Funds (SPIVA) shows that in the past year 86% of the large-cap funds weren’t able to beat the S&P100, the benchmark index for the segment. SPIVA compares the performance of actively managed Indian mutual funds with their respective benchmark indices. the same story is seen over a 3-year and 5-year period where 86% and 82% of the large-cap funds underperformed the benchmark.

safer than large-cap funds

in such a situation, the small and mid-cap space in India is still proving to be a safe haven for active fund managers who are in search of alpha, which is the excess return of a scheme over the benchmark return, on a risk-adjusted basis.

in the Indian equity mid and small-cap segment, 57% of the schemes underperformed their benchmark on 1-year returns. over the 3-year and 5-year period 48% and 69% of the schemes, respectively, have generated returns less than the benchmark, as per SPIVA.

no wonder fund managers turn to the small and mid-cap space in search of ‘hidden gems’ which can generate multi-bagger returns for them.

are there any pitfalls?

so are small funds always the go-to for better returns? not really.

usually, the difference in the first and third quartile funds is quite high. thich can prove challenging when it comes to fund selection. also, the problem with the small-cap stocks is that they fall as sharply as they rise and can take a huge time to regain their past glory.

look at the recent past

the small-cap space in India rose to prominence in the calendar year 2014, where most schemes gave upwards of 50% return and the momentum carried on through 2017. but the euphoria fizzled away in January 2018, post which the small and mid-cap continued to underperform the broader market until the start of the recent bull-run.

while it’s an established fact that the small-cap space is highly risky and volatile but for the amount of risk it brings, it rewards investors in kind only over the long term.

data from Morningstar shows that in the last five years, small-cap funds as a category gave annualized returns of 18.8%, whereas the large and multi-cap categories generated 16% and 17.7%, as of November 10, 2021.

over a period of 10 years, small-cap funds on average gave an annualized return of 19.8%, against 13.8% in the large-cap and 17.3% in the multi-cap category.

accounting for the risk-return trade-off, small caps seem to have an edge over the large-cap segment when one stays invested over the long term.