The Mutual Fund Show: Two Experts Suggest How To Look At Small-Cap Funds
Gold casting grain at a foundry in Russia. (Photographer: Andrey Rudakov/Bloomberg)

The Mutual Fund Show: Two Experts Suggest How To Look At Small-Cap Funds

Small-caps benchmarks have returned more than 100% gains in the past year. Is it still worthwhile to consider funds investing in such stocks?

It’s a tricky phase for small caps as returns in the category can be lumpy, according to Gurmeet Chadha, the co-founder at Complete Circle Consultants. While the dispersion or range of returns can be high for a long period of time, Chadha advises choosing small-cap funds that have seen multiple cycles.

Amol Joshi, a mutual fund adviser, said small-cap funds should be part of the portfolio if the time horizon is seven to 10 years. He cited the example of Budget 2018 when 10% long-term capital gains tax was introduced on equities. While small caps went through a bearish phase for about two years, they bounced back, Joshi said.

But investors should consider small caps only if they can stomach this kind of volatility, he said. Large drawdowns can be a big risk in these funds so lumpsum investing may not be a good idea, he said.

Joshi recommended the ICICI Prudential Smallcap Fund. His reasons:

  • Relatively smaller assets under management at Rs 2,123 crore compared to big funds with assets of Rs 10,000-13,000 crore, so easier to manage.
  • Managed by Sankaran Naren, a very experienced fund manager who has seen many cycles.
  • Scheme is positioned for sectors that will benefit from increasing vaccine coverage during the pandemic like construction, real estate, entertainment.

Chadha recommends investing in SBI Smallcap Fund. His reasons:

  • Long-standing track record on consistency and manage cycles.
  • Fund manager has the ability to limit assets under management, and an individual can only invest Rs 25,000.
  • Better representation of multiple sectors in the small-cap segment.
  • Low beta of 0.86, so falls lesser than the market.

Also read: Is Gold Set to Tear Even Higher? Four Key Charts to Watch


As gold prices are rising, Chadha and Joshi recommend selectively choosing gold funds. But they cautioned returns of gold funds are not proportional to gold prices as these invest into stocks of mining companies—so these are not gold but equity investments.

These will be highly volatile compared to gold prices since there is equity as well as gold price risk, Joshi said. Most such companies are global so such funds get international exposure.

Tax Savings Fund

Chadha said investors should start a systematic investment plan rather than last-minute rush to invest in January.

He recommends the Mirae Asset Tax Saver fund because of the blend of growth and value.

His another pick is the Axis Long Term Equity Fund due to the consistency of the fund in delivering 14-16% returns for the last many years.

Joshi suggests the IDFC Tax Advantage Fund as it is a multi-cap scheme compared to the largest funds in the category that has high large-cap exposure, and outperformance may be difficult.

Because of its portfolio, Joshi said, the scheme is one of the best performing funds in the last one year—returns of 102% compared to the category average of 77%. And that the fund also has tactical sector allocation right by increasing exposure to commodities and cement and building materials in the last quarter.

Watch the full interview here:

Also read: The Mutual Fund Show: Crisil’s Top-Ranked Debt Funds

Read the edited excerpts from the interview:

Gurmeet, are you recommending small-cap funds to your clients? Why or why not?

GURMEET CHADHA: I think it’s an interesting discussion considering that we’ve seen small-cap funds post 100% plus returns, in the last one year, and we saw that in 2017 when people entered and made, and we saw that small-cap should be a part of the portfolio. There is no standard rule but essentially for moderate to high-risk investors, a standard formula which we worked on when we were in B schools was 40-40-20. 40% into large-cap in index, 40 multi-cap and 20 in between. But as I said there is no standard formula, and the returns by the nature of the beast is that the returns are lumpy and can really be. So, it should be there in the portfolio, the attribution analysis has to be spot on, the choice of fund has to be spot on too. I was looking at the returns, the 10-year returns, the index is 10%, the best performing fund is 23% and the worst performing fund is in single digit. So, a dispersion of 4-5% which we see in large-cap, the dispersion could be 15-20% over long periods and liquidity and the way the fund has managed various cycles. So, it’s easy to get carried away seeing one-year returns, but you should stick with guys who’ve seen bad cycles—Covid, 2008, 2018 correction, and draw the fact how did they manage. So, a lot of things must go into consideration but definitely should be in the portfolio.

Amol, does your view differ there or what do you believe small-cap funds are an integral part of the portfolio, even at the current valuations?

AMOL JOSHI: I believe that small-cap funds essentially should be a part of your portfolio if you have a horizon of 7 to 10 years or more. As Gurmeet rightly said, the returns are lumpy. He also alluded to 2018. So, we all remember during the 2018 budget, the equity LTCG from zero when it was brought back to 10%, you had consistent one-and-a-half to two years of bear market in the mid-caps and small-caps and the small-caps really took the brunt of it. Some of the stocks were down between 40 to 60% and from those levels we have now seen more than 100% of the recovery. If you can withstand this kind of volatility, if you truly have a conviction that your investment horizon is 7 to 10 years, and hence a couple of years, two or three or even more than three years of underperformance is not going to shake your conviction, only then you should be part of the small-cap investor group. That’s number one. Do we suggest investors? Yes, of course, for somebody who is planning for a long-term investment goal or a financial goal, for those people small-cap, could be a part of asset allocation within the equity category.

Amol, what are the funds at the current valuations — I would request you to keep in mind one that the valuations have moved up, even though we are still as an index undervalued compared to the median for the large caps and the mid caps, maybe, and the hypothesis is that an investor who is willing to put in money right now will stay invested for the medium term, and is willing to take a little bit of risk — that you’re recommending and why?

AMOL JOSHI: In the previous part, again, we heard about the high dispersion of returns. There is high dispersion between the assets under management also, just to use the word. So, we have small-cap funds from a 200-500 crore AUM, all the way to 10,000-13,000 crore of AUM. In a small-cap fund that has a 13,000 crore AUM, you’re not going to be able to maintain it just by 20, 30 or 40 stocks, most of the small-cap funds have in excess of 60-70 or sometimes 90 stocks as well. In a wide choice of a couple of dozens of funds, I would go with the ICICI Prudential Smallcap Fund. It’s relatively a smaller fund about 2,000-2,100 crore managed by Sankaran Naren. This fund has been actively investing into the opening up trade. What I mean to say by that is, the fund is currently overweight into construction, real estate and the entertainment industry, this fund has done the sectoral allocation right over the last one year and it forms a part of top quartile performance in last one-year given the sectoral allocation and the value theme that they are able to play over here. Now most of the times we don’t go by returns alone. The way we spoke just now, we are looking at sectoral allocation also. Now when you go for a small-cap fund, you really want to know what kind of small-cap allocation is there in the fund. Many of the small-cap funds, especially the larger ones have tried to keep the small-cap allocation to the bare minimum of 65% which is the regulatory mandate. The remaining 35% to manage redemptions or to manage volatility you have it majorly into large caps. However, this is one fund which has in excess of 84-85% in small cap. What I would call it? True to level, all of them will be true to level after scheme categorisation, but this one, more so.

Gurmeet, what is the fund or what are one or two funds that you recommend? Why?

GURMEET CHADHA: We have a focus as you rightly pointed out, and I agree with most points of Amol on AUM. I think the second-most aspect of true small-cap and Naren personally managing it is obviously an additional incentive to go look for it. I think what I like in this category is, SBI, Axis and DSP small-cap. SBI, the reason being, it has the longest standing track record on consistency and on managing cycles. I like a fund manager for his ability to moderate flows when he thinks that the valuations are high. So currently, you can only put 25,000 rupees per pan, it tells you that the fund manager is not greedy for flows and it has an SIP book of 280 crore. It helps you manage redemption pressure—liquidity can be an issue in down cycle, and in panic you can see large flows. So good SIP book is one, fund manager’s experience is one and also the representation of sectors which Amol more partially alluded to, you have 38 odd sectors, which are not completely represented in Nifty which are chemicals, textiles and some of the auto-ancillaries. There are so many of them and I think more better representation and better attribution analysis is what I like. SBI small-cap if you see, if you go for the holdings, there’s very good stock picking, they were very early into Dixon and got into cement early too with JK cement, they got some of the good pharma small and mid-cap names, and also that you have to be honest about the mistakes too. It’s the nature of the asset class so it’s good to accept them and move out of that. So, I like that agility. I like the sectoral and representation of the theme in the fund and as I said it has a fantastic track record. 13% over benchmark on a 10-year basis is significant alpha. Last point, it has low beta so it falls lesser than the market, 0.86 to be precise.

Gurmeet, what’s the risk to this category for anybody investing in a fund?

GURMEET CHADHA: A large drawdown, you can see up to 72% correction in 2008, 40% correction it falls more than Nifty in a down cycle. So, you have to be prepared for it. Prefer the SIP-STP route, that’s the best way to play this category over a long period of time.

Amol, the risk to this fund or the category?

AMOL JOSHI: Honestly when we come down to brass tacks, we know that the only thing that really rattles investors and especially a retail investors’ soul is the fall into returns. So as again Gurmeet rightly said, you seen it fall anywhere between 40% to 60%, sometimes more. If you cannot handle that, then the entire thesis of investing into small-cap goes out of the window. You will probably sell it at a loss and move out and never come back to small-caps or equity, again. So, I would say the biggest risk is being prepared for the large drawdowns and being also prepared for extended period of underperformance running into several years. The most recent in our memory we can say that two and a half years is the kind of extent of longer periods of underperformance. So, these two from my side.

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Amol, let’s talk about gold. The most common thing that everybody says is go out and buy a Gold ETF, and a lot of people have done that and maybe with the right advice too. I want to understand, aside of ETFs, what can a mutual fund investor do to take advantage of the rise in gold prices? Again, there is no saying that this is how gold prices will continue to behave. What’s your advice?

AMOL JOSHI: In my opinion, this is a very interesting question and there is more than one way that you can take benefit or rather, take exposure I would say in an asset allocation framework, you can take exposure to gold. First and foremost, as you mentioned ETFs, a lot of people have done it. Probably the biggest attraction of ETFs, is the low cost. If we go beyond low cost, if you go to a retail investor how retail invests and how most of the investors invest, they want to essentially take exposure via SIPs. Many of the brokers still—the brick and mortar or the older ones still do not offer the SIP facility. If you want to take exposure to gold via SIPs, you can simply go towards a gold saving fund. A gold saving fund is nothing but a mutual fund, which invests into Gold ETFs. So, here it is slightly costlier, of course, because it is not of an ETF structure. Other than ETFs, you can look at gold savings fund, that’s number one. Number two, why I mentioned this is, because it is a very interesting question. Although this is mutual fund show we can talk about something that truly benefits the clients so something like a Sovereign Gold Bond—this is really beneficial as it has various advantages. Any kind of financial product, if you look at it, there are costs. Sovereign Gold Bond is probably the only product that you can think of, which has no cost and on the top of it, it gives you 2.5% of annual interest and after everything is said and done, it is an ATM product. So, if you hold to maturity for a 5 or 6-8 year horizon, you do not have capital gains also. So, no expense ratio, 2.5% annual interest and you get gold pricing at the redemption, which is completely tax free. This is the second way. As I said there is more than one way of taking exposure to this theme. The third way is something which is thematic. We have discussed this many times on this very show about themes or sectors you can invest into. When gold prices rise, obviously, it does well, and gold mining companies also do well. I would say that you can take exposure to gold mining companies. Now, we don’t have a lot of gold mining companies in India. Most of the companies are international. You can take exposure to something like DSP World Gold Mining Fund, which invests into gold mining companies. But mind you, there is not just the risk of gold prices. There is associated equity risk as well. The companies are leveraged. If there were going to be a fall in the prices of equity or there were an equity crash, so to speak, even when the gold prices are robust, you will probably see a fall in prices of these shares and hence, the NAV will take a hit. So, these are the three options in addition to Gold ETFs what you can look at.

Gurmeet, Amol highlighted SGBs but not essentially a mutual fund product, there are liquidity issues notwithstanding, it’s probably a great product, but what’s your sense about a mutual fund way to play this, aside of ETFs?

GURMEET CHADHA: I think the Gold FOF, or the Gold Saving Fund is a good way to play it. You can’t really do SIPs or long-term allocations through ETFs as they have liquidity issues. We’ve seen that the NAV really having large tracking errors because of the market marking issues. So, one is the Gold Saving Fund. Typically, you should divide it into two parts. One is, you want to play gold tactically, as a hedge against a black swan event and gold does well. In 2015-2019, almost flat returns and then we’ve seen last year. We’ve seen 2008 to 2011, there were very good returns post the global financial crisis. So, the Nifty correlation of gold is 0.05. So, it offers very low or almost like negative correlation. So, divide the tactical into a savings fund or ETF where the allocation is very large, divide the long-term thing into as Amol said, Sovereign Gold Funds. We’ve had 10 tranches and no capital gain after eight years, it gives you 2.5% interest, and you can keep averaging out because of the various tranches. Gold Mining Fund is not gold. It’s an equity allocation as a derivative of gold prices. So don’t confuse it with gold, we are doing asset allocation that is still equity.

Aside of the Gold ETFs and Sovereign Gold Bonds which are not essentially a mutual fund option, there very few mutual fund options to play the gold price rise, right?

GURMEET CHADHA: There are enough. Nippon was the pioneer in getting into a Gold Saving Fund. We have Kotak, SBI, Birla—almost all large fund houses. Axis has a one Gold Saving Fund too. Go for the lowest tracking error. Off-late, I’ve spent some time and the funds are evolving. The tracking error so far has been contained to less than 1%, which also includes some expenses. Be mindful of the expense because if the expense is very high, tracking error would be also high so be mindful of the expense ratio and be prepared that this is a hedge. The returns again in this could be that, you can have low periods of flat returns but this is a hedge in case something goes wrong and it may happen to crypto, it may happen to anything. It’s a hedge against that and maybe some hedge against the currency fluctuation.

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Gurmeet, the tax-saving fund. It’s such an important category and usually reserved for conversation around January, February and March. If someone doesn’t have a PPF and with all of those assumptions, what would you advise about tax-saving funds?

GURMEET CHADHA: Personally, I do SIP of the entire 1.5L and I think the reason is, you have to give more time for the compounding to happen. Even in a PPF, you get the minimum interest between the fifth and the end of the month. So, if you add to your PPF after the fifth, you miss out on a month. So, it is a simple thing, it allows investments more time, it gives you more control over cash flows, and mind you this is not an expense, which you have to comply because of ATC, it’s an investment. Don’t make it when you have so much pressure and you just go for it because you’re left with very few choices. Allow the cash flow planning and discipline to work out, allow the compounding to work out and don’t think of it as a three-year investment. The lock-in is three years and all the more reason you have to be very careful because you can’t do anything if you get your choice of tax saver wrong. So, plan well and this is part of your core allocation, this is something which will go into your retirement. So don’t think of it as a three-year, March-ending phenomenon.

Amol, what do you tell your clients when it comes to tax-saving mutual funds? Do an SIP every month? Is that a good thing and is right now a good time to start? Any advantages or disadvantages?

AMOL JOSHI: So, not just the tax-saver but for investments, there is no better day to start than today. So, we all have said that a number of times and we take every single opportunity that we can get to reiterate this, that’s number one. Number two, obviously SIP always is a good way to take exposure to any asset class especially so in equities, but rupee cost averaging is something that is a very good kind of benefit of SIPs that you do get. Any time when you want to invest and like you said, all of us should not wake up in January to March quarter and just dump Rs 1.5 lakh into the first person who comes to us with any fund or any product that will just give us a receipt in 24 hours and just be done with it, so don’t do that. If you plan and as Gurmeet rightly said, the lock-in is three years but funds can stay for as long as you want and since there is a lock-in, just like small-cap funds, this can be looked at as a long-term investment horizon. You also asked about advantages and disadvantages. In your question you also mentioned that we are keeping aside PPF for employees’ provident fund contributions. Now the key difference between those are fixed income products and ELSS Equity Tax Saver Mutual Fund is obviously an equity product. So, the disadvantages—you will not get consistently 7 or 8 or 12 or 14% return. Be prepared to look at some kind of volatility, including the capital going down. That’s the disadvantage I would say. The advantage is, it is one of the lowest lock-in products, you have tax saving fixed deposits, the lock-in is five years. The other tax-saving options, especially PPF and EPF—those are into multiple years, 15 years and probably longer than that for your EPF. So, the advantage is low lock-in. Other than PPF, you also have a taxation that is very friendly compared to a tax-saving fixed deposit of five years. The interest will get added to your income, however, here, equity taxation applies. LTCG is just 10%, so many advantages. But SIP or growth over and above fixed income and tax advantage, these are major advantages, in my opinion.

Amol, which is a good tax-saving fund? Are there are a couple of funds that you recommend?

AMOL JOSHI: In the market we have seen rotation in the last one year. The growth funds or so called growth sectors are currently not really the flavour. What is working is value. That’s why during small-cap funds also, we spoke about how that fund has taken the sectoral calls right. We also spoke about what is the kind of large mid and small-cap allocation that is there in the funds. Now this is one of the important parameters that we look at even while choosing the ELSS fund. So here I like something called as IDFC Tax Advantage Fund. It is a multi-cap fund, again here also there are funds of 10,000-20,000 crore sizes as well and just by the nature of the beast, just by nature of 20,000 crore of AUM, you have a large part going into the large-cap sector. Now this is essentially a multi-cap fund, you have about 50-51% into large-cap, and the remaining 45 to 50% into mid and small-caps. That’s why this fund has really done well over the last one year and over the last five years. In the last one year category returns are about 75-77%, this fund has delivered 102%. So, like you mentioned, small-cap has delivered 100% in one year, this is one fund which has 51% of large-cap and still, it’s right up there. We like the multi-cap orientation, we like that there is a sizable allocation to mid and small-caps which has done well. We also like that this fund has been able to get it sectoral calls right and currently they are overweight into commodities like cement and building material—all of these sectors. So, all of these points, to the better days for this fund going ahead as well.

Gurmeet, what about you, because you mentioned that it’s a really long-term thing, hold till eternity, so to say. What do you like and why?

GURMEET CHADHA: You know I prefer consistency as always in this category because this is one part of money, which you are actually comparing with more conservative options like PPFs and etc. So by design, I prefer it and I don’t think that a lot of our clients we speak to, make more exposure to a tax-saver because it also forces you to at least stay for three years and don’t react. So, we like two funds in this. We like the Mirae Asset Tax Saver Fund, that has done phenomenally well it has a great blend of growth and value, 70% large-cap, 30% mid and small-caps. So, if you see the holding, the top 10 stocks you will find the regular ones which are the banks, the Infosys and the Reliance of the world. They were early into Tata Steel they got into some good value themes, they got into chemicals on time. So, if you see the last five-year CAGR, it is about 21% plus. So, it’s generated phenomenal alpha and with pretty consistency. It’s been pretty consistent. The other one which we like is the Axis Long Term Equity, it is more concentrated in nature. So, the top 10 stocks make up 63% of the portfolio, almost 80% large-cap, and it’s a straight line if you plot three or five years or 10 years of return. It has basically 14 to 16%. So, I like that consistency, I like that sense of calmness because I also think it’s as much about customer experience in the category as about the overall returns.

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