Are you Sip-ping into the Right Small-Cap Mutual Funds?

A month later, the same investment journals and business dailies report that the SIP returns of equity-oriented schemes have started to improve. Undoubtedly, there has been an improvement supported by the liquidity-infused market rally and the participation of Robinhood investors in the Indian equity markets.

Graph: S&P Sensex Vs S&P BSE Smallcap

As evident from the graph above, the small-caps had been under immense pressure over the last 2-3 years. And when the COVID-19 virus gripped India, they were battered further. But from the March 2020 lows, the S&P BSE Small-cap index has gained +65%, while the S&P BSE Sensex is up +48% (as of August 21, 2020).

That being said, the wavering SIP returns have left mutual fund investors to wonder if SIPs in mutual funds, particularly small-cap schemes--that find their place at the higher end of the risk-return spectrum--should be continued or discontinued.

The recovery in the bell-weather index and the small-cap index instils hope of recovery to once again the peak (seen around a couple of years ago, in 2017 and 2018). But mind you, not all small-cap schemes may be worth keeping in the portfolio; they may not help generate the alpha returns you looking for.

The table reveals that not all schemes are faring well. Some are grossly underperforming the S&P BSE Small-cap -TRI across timeframes. While a few have managed to outperform, it was mainly supported by the market rally. If the broader market falls owing to the uncertainties caused by the COVID-19 pandemic, small-caps are likely to plunge more than large-caps.

Keep in mind, deteriorating macroeconomic conditions could make matters worse for the small-cap universe. Not all companies in this segment of the market capitalisation may be well-poised to take on headwinds. The highly leveraged ones may find it difficult to service their loans ---considering many of them are still not functioning at optimal levels, they are short of orders, supply-chain issues exist, demand remains muted, and liquidity is a concern. As the pandemic continues (the second wave of coronavirus is already reported in many parts of the globe), the smaller companies are likely to be more vulnerable and, in turn, all this would weigh on their corporate earnings.

Therefore, before taking a call whether to continue or discontinue SIPs in small-cap schemes, it would be worthwhile to holistically and scientifically (backed by thorough research) evaluate the underlying portfolio characteristics of the small-cap schemes you hold.

Besides, assess your risk profile. Small-cap mutual fund schemes are not for the fainthearted, as they tend to go from thrilling highs to dangerous lows. Only if you have the appetite for very-high risk and an investment time horizon of at least 7 years, consider small-cap mutual fund schemes, else give them a miss.

You see, it is important to add funds that are best suited to your investment objectives and asset allocation rather than adding them in an ad hoc manner even when taking the SIP route.

What you can expect?

The trailing 12-month P/E of the S&P BSE Sensex has scaled to nearly 28x versus sub-20x levels at the end of March 2020. On the other hand, valuations in the small-cap segment although relatively better placed --much lower than the levels recorded in 2017 and 2018 -- negative earnings in the small-cap segment is a concern. For small-caps to continue performing well, ultimately earnings will need to justify valuations. Otherwise, it may not augur well for small-cap mutual fund schemes.

Therefore, if you are SIP-ping into small-cap schemes, make sure you are holding the right ones that potentially can generate an 'alpha' (noticeably outperforms the benchmark).

Currently, to clock an 'alpha' in mutual funds, you need to follow an effective Alpha Booster Strategy.

If you wish to add a readymade portfolio of alpha funds and interested in multiplying you portfolio returns assuming high risk, my colleague, Mr Vivek Chaurasia - Head of Mutual Fund Research, has identified five high alpha-generating equity funds.

This Alpha Booster Strategy that has proven their ability to beat the benchmark and the category average by a noticeable margin. You may consider SIPs in these five high alpha funds.

Here are a few rules PersonalFN follows when selecting funds for the Alpha Booster Strategy:

• ✓ The portfolio has been built with a time horizon of at least 5 years

• ✓ It has been diversified across investment style and fund management

• ✓ Each fund in the portfolio is true to its investment style and mandate

• ✓ They are managed by experienced and competent fund managers and belong to fund houses that have well-defined investment systems and processes in place

• ✓ They are amongst top scorers (on our S.M.A.R.T. Alpha Score model) in their respective categories

• ✓ Each fund has seen at least 3 market cycles of outperformance and has proven the ability to generate alpha over the market index

• ✓ No two schemes will be managed by the same fund manager

• ✓ Not more than two schemes from the same fund house have been or will be included in the portfolio.

Backed by prudent investment processes and systems, the five Alpha Funds are driven by solid fund management that possesses virtuous stock-picking abilities and has the potential to generate significant returns for you over the next few years.

Click here to get access to PersonalFN's Alpha Booster Strategy.

Happy Investing!

Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter

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