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Best small cap mutual funds to invest in 2019

The small cap mutual fund category has offered double-digit negative returns in the last one year, but don't write them off.

ET Online|
Updated: Nov 14, 2019, 10.24 AM IST
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Here is the monthly update on our recommended small cap mutual fund schemes. We are happy to inform you that there are no changes in the recommendation list in November. Both the small cap mutual fund schemes that were in our list in July managed to retain their spot even this month.

The small cap mutual fund category has offered negative returns (-1.55%) in the last one year. However, many mutual fund advisors say investors should not write these schemes off. Many market pundits believe that small cap category may be poised to a comeback as there are pockets of attractive valuations in the segment. Even otherwise, if you are an aggressive investor, you should know that is it not wise to shun these schemes only because of their short-term underperformance and volatility. They are indeed volatile and risky in the short term, but they have the potential to offer superior returns over a long period.

That is why mutual fund advisors and fund managers say that you should never write off small cap mutual funds. In the long run, small cap mutual fund category has the potential to offer superior returns than other equity mutual fund categories. For example, the small cap mutual fund category has offered 12.15 per cent returns in 10 years.

If you are a new investor or you do not have a very high risk appetite and a longer investment horizon (minimum of seven to 10 years), it is better to stay away from small cap mutual fund schemes. Small cap mutual fund schemes are meant for aggressive equity investors who can stomach a lot of volatility and risk.

According to new Sebi guidelines, small cap mutual fund schemes must invest at least 65 per cent of their corpus in very small companies. Sebi has defined small companies as companies that are tanked below 250 in the stock exchange in terms of market capitalisation.

Because of their investment universe, small cap mutual fund schemes are extremely risky. They can be beaten down drastically in a sharp fall in the stock market or on the slightest bout of volatility. But small cap mutual fund schemes also have the potential to offer superior returns over a long period. This is because small cap schemes bet on small companies with a very high growth potential. When a small company becomes a very large company, the shares of the company would appreciate multiple times. To put it simply, small cap stocks can be the coveted multibaggers every investor dreams of owning.

However, do not chase returns and get into small cap mutual fund schemes for a short-term. That is a sure way to lose money. Choose small cap mutual fund schemes if you have a long-term investment horizon and a high risk appetite. Continue with your investments or hold them for a long term to earn big returns. Here are our handpicked small cap schemes for you.

Best small cap mutual funds to invest in 2019
L&T Emerging Businesses Fund
HDFC Small Cap Fund

If you are keen to know about our methodology, scroll down to read. However, before that a word about the periodic exclusion or inclusion the list. Since we follow a quant-based methodology, some schemes may get out of the recommended list. Some may also find a place in the list. That doesn’t mean that you should stop investing in schemes that got out of the list.

Follow the usual practice when it comes to reviewing your mutual fund portfolio. Review at least once a year. And if the scheme has beaten its benchmark and category average, continue with it. If it fails to beat its benchmark and category for more than a year or two, find out the reason for the under-performance. If you don’t find the reason convincing, you may sell your investments, and start investing in a better performer in the same category.

Our methodology: Mutual Funds has employed the following parameters for shortlisting the Equity mutual fund schemes.
1. Mean rolling returns: Rolled daily for the last three years.
2. Consistency in the last three years: Hurst Exponent, H is used for computing the consistency of a fund. The H exponent is a measure of randomness of NAV series of a fund. Funds with high H tend to exhibit low volatility compared to funds with low H.

i) When H = 0.5, the series of return is said to be a geometric Brownian time series. These type of time series is difficult to forecast.
ii) When H <0.5, the series is said to be mean reverting.
iii) When H>0.5, the series is said to be persistent. The larger the value of H, the stronger is the trend of the series

3. Downside risk: We have considered only the negative returns given by the mutual fund scheme for this measure.

X =Returns below zero
Y = Sum of all squares of X
Z = Y/number of days taken for computing the ratio
Downside risk = Square root of Z

4. Outperformance: It is measured by Jensen's Alpha for the last three years. Jensen's Alpha shows the risk-adjusted return generated by a mutual fund scheme relative to the expected market return predicted by the Capital Asset Pricing Model (CAPM). Higher Alpha indicates that the portfolio performance has outstripped the returns predicted by the market.

Average returns generated by the MF Scheme =
[Risk Free Rate + Beta of the MF Scheme * {(Average return of the index - Risk Free Rate}

5. Asset size: For Equity funds, the threshold asset size is Rs 50 crore

(Disclaimer: past performance is no guarantee for future performance.)

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