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Planning to Buy Small Cap Funds in 2020? Here Are Some Tips

2020 is expected to be the year of small-cap stocks. With the country recovering from the economic slowdown, equity, especially small-cap stocks, might have brighter days ahead. If you are planning to invest in small-cap mutual funds in 2020, how should you select the top fund? Read this post to find out.

India witnessed considerable economic slowdown in 2019. With several indicators now pointing towards the long-awaited recovery, 2020 can be an excellent time to dip your toes into the equity market.

Quality small-cap stocks have historically been known to outperform large-cap and mid-cap stocks in a bull market. If you don’t have the expertise to pick quality small-cap stocks, investing via small-cap mutual funds could be a wise option.

But just like picking stocks, you need to choose the best small-cap fund. While selecting a mutual fund scheme is considerably easier than stock selection, there are a few important things you should keep in mind before investing.

Here are a few tips to help you select a top small-cap fund in 2020.

1. Portfolio Composition

Check the portfolio composition of the scheme you are interested in. Every mutual fund schemes must provide detailed information on the portfolio composition. You can find this on the official website of the fund house. Diversification is one of the primary goals of investing in small-cap funds. So, prefer schemes that have quality small-cap stocks from all the different industrial sectors, like banking/finance, IT, pharma, automotive, etc.

2. Historical Performance

A lot of investors select mutual funds based on a list of top performers that they find online. But these lists mostly only consider the recent performance of the scheme. Experienced investors know that the recent performance of a scheme in no way guarantees its future potential. Look for consistency in returns across market cycles both on a short-term and long-term basis. Analysis of performance consistency in the last 1-year, 3-year, and 5-year will help you select a far better scheme as compared to only considering the recent performance.

3. The Financial Ratios

Financial ratios are also an integral part of mutual fund evaluation. Some of the most important ratios that you should analyse are:

  • Sharpe Ratio:

    The risk-adjusted portfolio returns are measured with the Sharpe Ratio. Schemes with higher Sharpe Ratio are considered to have more potential as compared to schemes with a lower Sharpe Ratio.

  • Standard Deviation:

    The Standard Deviation represents the annual expected rate of returns along with volatility. Schemes with a high Standard Deviation are considered to be more volatile and risky as compared to schemes with a lower Standard Deviation.

  • Beta:

    The Beta indicates fund sensitivity in relation to the benchmark. For instance, if the Beta of a mutual fund scheme is 1, the volatility of the fund and that of the benchmark it tracks is similar. If the Beta is 1.4, the fund is 40% more sensitive to the price movements of the benchmark. Funds with higher Beta are more volatile but generally also have a higher return potential.

  • Alpha:

    Alpha indicates the profit-generating ability of a mutual fund scheme when its underlying benchmark is generating profits too. For instance, if the Alpha of a small-cap fund is 1, it is generating as much profits as its underlying benchmark. If the Alpha is 1.4, the fund is generating 40% more profits than the benchmark. Higher the Alpha is, the better is the ability of the fund to generate higher returns than its underlying benchmark.

4. Fund House and Fund Manager

Finally, is the fund house offering the scheme and the fund manager of the scheme. It is always better to select a reputed fund house when searching for a top small-cap mutual fund.Prefer fund houses that have been in the industry for a long time and offer many different types of mutual fund schemes apart from the small-cap scheme you are interested in.

Similarly, the fund manager should have extensive experience in managing small-cap funds. The ability of a fund manager to manage the scheme across market cycles is critical when selecting a small-cap fund.

Consider Professional Help When Needed

Small-cap mutual funds are generally riskier than other equity funds like large-cap and mid-cap funds. Even if you believe that you have a higher risk appetite, which is needed for these funds, you should be careful with fund selection.

While a lot of investors do analyse the funds and select them on their own, you should always consider professional help if you are new to small-cap funds. Also, it is generally recommended that one should only have limited exposure to small-cap funds. Consider your investment horizon and financial objective to be able to make the right investment decision.