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Mistakes to avoid for choosing the best small cap mutual funds

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Small cap mutual funds invest in shares of small and mid-sized companies which have market capitalization between Rs 100 crore to Rs 5000 crore. They have the potential to give higher returns than large cap funds but are also riskier.

Common Mistakes to Avoid

Here are some common mistakes to avoid while choosing best small cap mutual funds:

Going by Past Returns

Don’t just look at the 1-year or 3-year returns of a small cap fund. The fund category is very volatile and past returns may not sustain. Instead check the long-term performance across market cycles. A fund that has done well in both bull and bear markets is a better pick.

No Exposure to Small Caps

Many investors make the mistake of not having any allocation to small caps at all due to their risky nature. However, a 10-15% exposure can help boost overall portfolio returns over the long run. Avoid very high concentrations though – a 20-30% allocation is sufficient.

Picking unsustainably high performing funds

Often the small cap mutual funds which have given very high returns in a short period tend to attract a lot of investor money. However, such performances may not be sustainable. It’s better to choose funds with relatively more modest but consistent long term track record.

Ignoring Portfolio Concentration

Some star small cap funds end up with a concentrated portfolio because they take high conviction bets. However, this leads to higher volatility. It’s better to choose a multi-cap fund with some exposure to small caps or a small cap fund with a diversified portfolio of at least 50 stocks.

Falling for Fancy Fund Names

Many small cap funds have attractive sounding names based on their investment strategy – for example focused, emerging businesses, microcap etc. However, don’t get swayed by names. It’s the portfolio and performance across market cycles that matters more.

Chasing lower NAV

Some investors prefer funds with lower Net Asset Value (NAV) in the belief they have more upside potential. However, a high or low NAV itself means nothing but it’s the percentage growth in mutual fund NAV that generates returns. Also, funds do not have an optimal size – a large fund can also perform very well.

Not Comparing with Benchmark

While analysing small cap funds, you must check their performance against their benchmark index i.e. the Nifty Small cap 100 index. A fund that has consistently outperformed the benchmark over long periods of time has a higher probability of doing well in the future too.

Frequent Changes

Small cap funds tend to have higher volatility. Don’t frequently change your fund just because of 1-2 quarters of underperformance. Give it time to deliver – at least 3-5 years. Frequent changes will only increase your costs.

Ignoring Valuations

Valuations play an important role in the small cap segment. During times of very high valuations, future returns tend to moderate. Therefore, also analyse the valuation metrics of the portfolio before investing at a particular time.

Not Reviewing Regularly

Once you have chosen a well performing small cap fund, don’t just forget about it. These funds need regular monitoring, at least once every six months. Track changes in the portfolio, strategy, expense ratio, performance etc. and take necessary action when required.

Conclusion

Small cap funds have the potential to enhance your portfolio returns but can also be volatile. Avoid the common mistakes listed above and choose your funds carefully. Give utmost importance to long term performance across cycles, portfolio concentration, fund management team’s expertise etc. Invest for long periods and monitor your funds regularly. This will help you get decent risk-adjusted returns from your small cap fund investments.

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