I have been reading a lot of articles, blogs, answer to questions on finance / investment portals regarding investment in small caps. While there is consensus on the fact that small caps do provide higher returns in specific periods, it is always followed by a question on the risks they possess and hence whether they are worth investing in.
What I was surprised by, was a few experts totally shunting small caps in favor of large caps arriving at the conclusion that returns of small caps are not worth the risk they carry and investment in smallcaps should be avoided.
There are various metrics which are used to measure risk such as standard deviation, beta, sharpe ratio, rolling returns, etc. Now some of these are very difficult for the common man to understand. So can there be another way in which we can look at returns and risk to evaluate large and small caps?
So what is the risk small cap funds carry against large caps? Simply speaking it’s the fact (or fear) that say if both are purchased for INR 100, even though if small cap go upto INR 200 (100% up) while large cap in the same period goes upto INR 170 (70%), there is a possibility that small cap in subsequent periods can go down to INR 120 (40% down from 200) while large cap in the same time would fall to INR 136 (20% down from 170).
So in this example, volatility of small cap is the stock moving from 100 to 200 and then again back to 120; whereas large cap was more range bound from 100 to 170 and then 136.
Now taking this example above, let us see what happens if we did monthly SIP of INR 5,000 in small caps and in the UTI NIFTY 50 since 2011. Instead of taking a largecap fund, I have taken comparison with an index fund since again there is a lot of consensus on index funds beating most largecap funds.
According to this table had an investor started a monthly SIP of INR 5,000 on 01-01-2011 in any of the 7 small cap funds shown above then, upto 2017 he would have always had a higher corpus as compared to UTI Nifty 50 fund. In 2018, UTI Nifty 50 would takeover ICICI small cap fund similar to shown in our example earlier. However, UTI Nifty 50 does not beat any of the other 6 smallcap funds in any of the 12 periods analyzed.
Of the other 6 funds, the minimum corpus garnered as of 30/06/2024 is of HDFC small cap of INR 39 lakhs as compared to corpus of INR 23.24 lakhs for UTI Nifty index fund. This means if UTI Nifty 50 were to beat HDFC small cap fund, HDFC small cap fund has to fall by 40% more than the UTI Nifty 50 fund. Now this has not happened in the last 12 years atleast. What is more evident that whenever there are high growth rate period for small caps, the accumulated corpus of 6 out of 7 small cap funds gets further ahead of UTI Nifty 50 index fund.
Now the corpus in the table above is based on the NAV of the 1st day of the year. So the accumulated corpus for 2011-17 is based on the NAV of the 1st trading day of 2018. Further elaborating on the risk aspect, the highest level of risk is if an investor has to liquidate his investment on the lowest NAV during the year. So hypothetically if we consider the value of HDFC small cap fund at the lowest NAV for the year, even in this scenario the accumulated corpus never goes down below that of UTI Nifty 50 index after 2014. The result is the same for the other 5 small cap funds. So even if at the lowest NAV in the year, the accumulated corpus for small cap remains higher than that of UTI Nifty 50 index, are small caps really that risky in the long run?
This analysis was done taking 2011 as the base year for starting monthly SIP. In Part 2 of this series we will analyze data taking another year as the base year and see what the results throw up.
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