Best Small Cap Mutual Funds To Invest In 2022

In this article we cover

• 1) What is a Small Cap Mutual Fund?

  2) 4 Point Checklist Before Investing in Small Cap Mutual Funds

  3) Taxation of Small Cap Mutual Funds

Small cap mutual funds are one of the riskiest types of mutual funds in existence. This is because they invest in budding companies, most of which are start-ups. But however risky, small cap mutual funds do give you a great investment opportunity. You get a chance to invest in companies which are just taking off. The payoff in the case of small cap mutual funds is mammoth. This is because these companies are yet to experience their huge growth spurt.

But not all small cap mutual funds are the best. You see, unlike large cap funds, selection is key in the case of small cap mutual funds. This is because there is limited information available regarding small cap companies in the public domain. For example, a stock like Infosys Ltd is well-tracked whereas most small cap stocks aren’t. This happens because these companies are so small that they often do not regularly report their revenue numbers. Their small scale helps them fly under the regulatory radar. This makes them highly risky. This is why the fund manager of a small cap fund is extremely critical in the grand scheme of things.

Hence, selecting the best small cap mutual fund is the key. And the most important part is to not be swayed by their high returns. For example, Nippon India Small Cap Fund gave a stellar return of 70.03% in the last one year (as of January 30, 2022). The fund invests in 135 stocks. But only 24 stocks are worth investing in as per RankMF’s proprietary giga trading engine. This is why, in the case of small cap funds, studying the fundamentals of the fund’s underlying portfolio is key.

Now, we at RankMF believe that the underlying portfolio is god. This is why you would be surprised to know that as per us, there is only one best small cap mutual fund in India. Yes, there are 24 open-ended small cap mutual funds in India as of December 2021. The total assets under management (AUM) is worth a whopping Rs 1,02,632 crores. Some of these small cap mutual funds schemes have been in existence since the 1990s. Here is the list and performance of all small cap mutual funds in India in 2022.

Quant Small Cap Fund is the top performing small cap fund in 2022 with a one-year return of a whopping 89% (as of February 2, 2022). But we aren’t impressed. For us, only one small cap fund is worthy of being called the best small cap mutual fund in India. Which is this one best small cap fund? We’ll reveal this shortly. But before that, let us look at what are small cap mutual funds, their features and their performance.

What is a Small Cap Mutual Fund?

Here is the official definition of a small cap mutual fund as per the Securities and Exchange Board of India (SEBI) –

A small cap mutual fund is an open-ended equity scheme which invests a minimum 65% of its total assets in stocks of small cap companies.

Now, conveniently, the SEBI has divided all the stocks listed on the stock exchanges in three parts –

• The first 100 stocks as per market capitalisation are known as large-cap or blue-chip stocks.
• Stocks ranging from 101st to 250th in terms of market capitalisation are mid cap stocks.
• All the stocks from 251st stock onwards are your small cap stocks.

There are around 4,000 stocks listed on stock exchanges in India. Of them, remove the first 250 stocks. So, more than 3,700 stocks are small cap stocks. Now you can imagine why stock selection is key in small cap mutual funds. Because the universe itself is so big, it is easy for fund managers to get carried away and invest in the wrong stock. But it also gives them the opportunity to find outperformers like Galaxy Surfactants Ltd (up by 49.77%), Elantas Beck India Ltd (up by 28.43%) in the last one year.

So, in short, small cap mutual funds invest 65% of its total assets to buy shares of small cap companies. The remaining 35% can be invested in large and midcap companies. It can also be maintained as cash to take care of redemption pressures.

The pie-chart below shows the portfolio of SBI Small Cap Fund – the second biggest small cap fund in India in terms of AUM.

The 92.40% in equity is further divided as 43.63% in midcap stocks and 56.37% in small cap stocks. Now, it is important for you to understand the asset break-up of small cap funds. This small detail can help you decide whether or not you should invest in the fund. But that’s not all. Here’s a checklist of the parameters you should check while investing in best small cap mutual funds.

4 Point Checklist Before Investing in Small Cap Mutual Funds

• Risk Profile and Time Horizon :

  Investing in a small cap mutual fund is not a short-term activity. Think about it… can a Blue Star become a Voltas overnight? No, it obviously needs time. Similarly, your investment in a small cap mutual fund needs to be nurtured. So, if you cannot stay patient for a minimum of 10 years, then you should not invest in small cap mutual funds. The short-term returns might tempt you, but small cap funds are not safe for the short-term.

  For example, the below graph shows the performance of Franklin India Smaller Companies Fund. Now ask yourself, can you handle going from 43.46% return in 2017 to (-)17.33% return in 2018? If the answer is no, then you should not invest in small cap mutual funds.

  

• Strength of the Underlying Portfolio :

  We cannot stress enough on this point. Stock selection is crucial for small cap mutual funds. And obviously there is a lot of room for error here. After all there are more than 3,700 small cap stocks in India. This is why you must ensure that the portfolio of a small cap mutual fund is adequately diversified. For instance, the table below shows the total number of stocks owned by difficult small cap funds.

  The portfolio of Nippon India Small Cap Fund looks over-diversified. On the other hand, the portfolio of Invesco India Small Cap Fund seems under-diversified. Our goal is to find an adequately diversified fund. This way, you do not face concentration risk.

  Small Cap Funds	No of Stocks
  Nippon India Small Cap Fund	135
  Invesco India Small Cap Fund	48
  RankMF's Recommended Best Small Cap Fund	76

  Note :*Portfolio as of 31st December 2021
  

• Exposure to Top 10 Stocks :

  This is an extension of the above point of diversification. Always ensure that your small cap fund is not overly invested in select small cap stocks. The fund’s exposure to top 10 stocks should not be more than 25-30%. This is another way to eliminate concentration risk.

  • DSP Small Cap Fund has 31.42% exposure to the top 10 stocks.
  • Kotak Small Cap Fund's exposure to its top 10 stocks is a mammoth 35.78%.

  But RankMF’s recommended best small cap fund’s exposure to its top 10 stocks is 20.91% only. This again proves that our recommended best small cap fund is adequately diversified.

• Cash Holding :

  This is a very important point while selecting the best small cap fund. Small cap stocks have very low liquidity. Now individual retail investors would find it difficult to buy and sell stocks during the day. Can you imagine the pickle the fund manager is in, if he wants to exit a stock immediately? Take the example of ABB India Ltd and Craftsman Automation Ltd. Both stocks belong to the engineering sector.

  • ABB India Ltd.’s average daily turnover is around 2.5 Lakhs (as on February 2, 2022)
  • Craftsman Automation Ltd is a small cap engineering company. Its average daily turnover is only (~) 15,000.
  
  

  Now, Invesco India Small Cap Fund invests 3.20% of its assets in Craftsman Automation Ltd. With such poor liquidity, it would be difficult for the fund manager to exit the stock during an emergency. This is why the cash holdings of small cap fund is crucial. Majority of small cap funds invest 100% of their corpus in stocks of small cap companies. They barely maintain any cash to take care of redemption pressures. This is a big no. So, always invest in only those small cap funds which earmark cash assets to deal with redemption pressures.

Now, I promise this is the last stop-over before I reveal the name of the best small cap mutual fund in 2022. But we have to discuss the taxation of small cap funds.

Taxation of Small Cap Mutual Funds

There are two types of taxes applicable to your small cap mutual funds.

• Long Term Capital Gains Tax (LTCG)
• Short Term Capital Gains Tax (STCG)

LTCG tax is applicable when you sell your small cap fund after a period of one year. The LTCG tax on small cap mutual funds is 10% over and above capital gains of Rs 1 Lakh in a financial year. STCG Tax is applicable when you sell your small cap funds before one year. You have to pay a flat STCG tax of 15%.

And now the wait is finally over. The best small cap mutual fund is India is UTI Small Cap Fund.

UTI Small Cap Fund was launched on December 22, 2020. It has generated a return of 49.93% since its launch. Its AUM is Rs 2,016 crore (as of December 31, 2021). This is decent considering that the AUM of Kotak Small Cap Fund is Rs 6,762 crore, despite it being launched in 2005. UTI Small Cap Fund follows a growth strategy and invests in a total of 76 stocks. The graph below shows the fund’s allocation against its peers.

The fund is bullish on midcap stocks. It invests 55% in midcap stocks against category average of 48%. While it invests 45% in small cap stocks against a category average of 50%. The best small cap fund in 2022, UTI Small Cap Fund is bullish on the following sector –

Here are the five things that make UTI Small Cap Fund India’s best small cap mutual fund in 2022

• The expense ratio of the fund is 2.25%. This is 73% lower than the small cap category average.

• The fund’s turnover ratio is only 8.16%. This is 79% lower than other small cap funds. This solidifies the fund’s long-term investment approach.

• The fund holds 2% of its corpus in cash to fend redemption pressures.

• The fund holds only 20.91% of its assets in the top 10 stocks. This means there is minimal concentration risk.

• The fund follows a pure growth strategy with a price to earnings ratio of 34.92.

This concludes our discussion on the best small cap mutual fund in 2022. Now to invest in the best small cap fund in India, you simply need to open a FREE mutual fund investment account with RankMF.