Small cap funds: How to evaluate performance using benchmarks and other metrics

Small cap funds invest in the stocks of companies that are ranked 250 and beyond in terms of market capitalisation on the stock exchange. Small cap stocks tend to have a higher return potential than large and mid cap stocks because they invest in growing companies, but they carry significantly high risks too.

Investors should choose small cap funds after conducting thorough research. For this, they must understand the small cap performance metrics and benchmarks. This information can help investors identify well-managed funds and potentially benefit from the growth potential of smaller companies while mitigating risks.

• Table of contents

1. Understanding benchmarks for small cap funds
2. Key metrics for evaluating small cap funds
3. Importance of benchmarks in evaluating small cap mutual funds
4. FAQs

Understanding benchmarks for small cap funds

The Nifty Smallcap 250 TRI and S&P BSE 250 Small Cap TRI indices are some of the commonly used benchmarks for small cap funds in India. Every mutual fund scheme mentions its benchmark in the scheme information document.

Comparing the scheme’s returns to the benchmark helps investors evaluate how well the fund is performing relative to the overall small cap market segment. Investors should also look at the returns of other schemes in the same category. A single fund’s return in isolation – no matter how promising it may seem – does not provide a complete picture. Comparing it with the benchmark and category peers shows how the scheme is performing in relation to the overall market trends and its competitors.

Key metrics for evaluating small cap funds

Apart from returns, some mutual fund and small cap performance metrics include alpha, beta, standard deviation, Sharpe ratio and R-squared. These give an overview of the fund’s risk-adjusted returns. Here is an overview of these metrics:

• Alpha: It is the measure of an investment’s performance relative to its benchmark index. Fund managers in actively managed funds seek to generate alpha, i.e., perform better than the benchmark. A positive alpha indicates that the fund’s returns have exceeded the benchmark.
• Beta: A measure of volatility, beta indicates how much a fund’s portfolio fluctuates in response to market movements. A beta of one indicates that the movement of the portfolio is in line with that of the benchmark and therefore, the wider market. A beta of less than one indicates that the fund was less volatile than the overall market, while a beta over one indicates higher volatility.
• Standard deviation: Standard deviation measures the deviation or difference between a set of data points. For mutual funds, standard deviation measures how much the portfolio’s return has strayed from its average return. The average return is determined based on the fund's historical performance.
• Sharpe ratio: To calculate Sharpe ratio, the average return of a fund is subtracted from a risk-free rate of return (like the return on a safe investment such as treasury bills). The result is then divided by the standard deviation of the fund’s returns. This shows how much return the fund is giving per unit of risk taken. A higher Sharpe Ratio indicates better risk-adjusted performance, meaning higher returns for the amount of risk taken.
• R-squared: R-squared measures how well a fund’s performance matches its benchmark. In other words, it shows how much a fund’s movements are a result of movements in the benchmark index. It's a value between 0 and 1, where 1 indicates a perfect correlation.

Importance of benchmarks in evaluating small cap mutual funds

Benchmarks serve as yardsticks to evaluate how well a small cap mutual fund is performing. For instance, if a small cap fund generates lower returns than its benchmark over a period, it indicates that the fund has underperformed the overall small cap market. The importance of benchmarks in evaluating small cap mutual funds is that they provide a basis to gauge the performance of a fund relative to the overall market.

Comparing a fund’s performance with that of its benchmark index can also help investors gauge if a fund is adding value through active management after adjusting for market movements.

Additionally, looking at performance metrics like alpha, beta, standard deviation etc. can give a more holistic view of the fund’s performance in comparison to the risk it has taken.

Conclusion
Evaluating small cap funds against suitable benchmarks gives insight into a fund’s performance across market cycles. In addition, metrics such as Sharpe ratio, standard deviation and R-squared show the risk-adjusted returns. This can help investors choose funds that have consistently added value after adjusting for market risks. However, past performance alone should not drive investment decisions about small cap funds. Investors should also consider their investment goals, risk appetite, investment time horizon and assess qualitative factors before selecting a small cap fund aligned to their requirements.

FAQs:

How do small cap funds differ from large cap and mid cap funds?
Large cap companies are the top 100 in the stock exchange in terms of market capitalisation, while mid cap companies are ranked 101 to 250. Small cap funds invest in companies ranked 251 and beyond. Such securities tend to be more volatile as they invest in companies that are relatively less well-established. However, small cap funds also offer higher growth potential than large and mid cap firms because these companies are in the growth phase. So, they may be suitable for long-term investors with a high risk appetite.

Are small cap funds suitable for all investors?
Small cap funds may not be suitable for risk-averse investors given their high volatility. Small cap funds can be a part of a diversified portfolio so that investors can seek to benefit from the return potential while mitigating risk.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as an endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purposes only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals, and horizon. This information is subject to change without any prior notice.