You can’t avoid double-digit negative returns in small cap mutual funds

Many investors are waking up to the presence of volatility and risk in small cap schemes these days. The negative returns offered by small cap schemes in the last two years have prompted many investors to ask whether they can afford to stay invested in these schemes.

ETMutualFunds.com has been receiving many queries about the underperformance of small cap funds in the last two years. Unnerved by the large losses, many investors wanted to know whether they should exit the schemes.

For the record, BSE SmallCap index has fallen 35% from the high levels of 20,000 in January 2018 till date. The small cap funds category has fallen by 17% on an average in the same period. They have generated negative returns (10% CAGR) during the period.

ETMutualFunds.com analysed the data to find out the performance of small cap schemes over a long period. We also looked at the worst returns generated by these schemes in different time periods. We used rolling returns instead of trailing returns.

You must understand the concept of rolling returns before proceeding further. Read this: Is 'rolling return' the best way to measure performance of mutual funds?

The idea is to find out the worst performance an investor can expect from these schemes and to figure out if there is any point in staying put with these schemes or should investors move out given the kind of returns and risks involved in small cap schemes.

Look at the short-term data. HDFC Small Cap Fund, the biggest fund in the small cap category, has given -8% returns in the last one year. Rolling the returns since the inception of HDFC Small Cap Fund showed that the worst return given by HDFC Small Cap Fund in the one-year period was -34.51%.

Similarly, DSP Small Cap Fund which has given the highest maximum returns of 214% in one-year period has also given the worst one-year returns of -67.43% at some point, which is the lowest in the category as well.

We have taken these names as examples. You should not take the examples as any kind of advice or recommendation.

All the schemes in the small cap category had offered double-digit negative returns during the worst phase in their existence.

In the two-year horizon, the minimum worst rolling returns given by the small cap funds have improved than one-year period, but they are still negative for all the schemes. Axis Small Cap Fund was the only exception: the scheme offed 2.88%.

HDFC Small Cap Fund has given the worst returns of -6.78% and DSP Small Cap has given -13.60% compounded in the two-year period at some point of time since their inception. We have taken the same names for comparison.

The lowest 2-year returns generated by a small cap scheme is -42% CAGR.

What happens as we increase the investment horizon? Data shows the minimum returns generated by the small cap schemes improved as we increase the investment horizon.

For an instance, in the five-year period, the lowest returns generated by small cap schemes were in the range of -12% and 15% CAGR. Eight out of 14 schemes generated positive minimum returns for investment horizon of five years.

An investment horizon of seven-years showed even better results. The minimum returns in the category were in the range of -2.45% and 19.2%. Only one scheme gave negative minimum returns.

The minimum 7-year returns generated by HDFC Small Cap Fund at some point of time since its inception was 11.34% compounded, far better than the minimum returns generated in lower investment tenures.

The data shows that small cap funds are very risky for the short-term investors. However, the probability of getting positive returns in the worst-case scenario improves over long horizons.

That means, you should invest in small cap schemes only if you understand the risk involved in them and have a long-term horizon of over seven years or even higher.

Existing investors who are concerned about the negative returns in the small cap schemes in the last two years should first make sure that they have the necessary risk appetite. If yes, they can stick to the good schemes in the category and ignore the short-term volatility. If their risk profile is not suitable to invest in small cap schemes, they should exit and choose a conservative or less aggressive category.