Should investors choose passive funds for smallcap market exposure?

While active smallcap funds have traditionally outperformed benchmarks, passive and smart-beta options offer lower costs and diversified exposure. The choice depends on investor preference and convict

The launch of the ICICI Prudential Nifty Smallcap 250 Exchange-Traded Fund (ETF) has brought passive smallcap funds back into focus. Investors now have 27 passive smallcap funds to choose from: 17 index funds and 10 ETFs. Investors should assess whether an active or passive approach suits them better. If they decide to go passive, they also need to choose between market-cap-weighted indices and smart-beta indices.

 

Conventional advice

 

Financial advisers have traditionally recommended passive funds for the largecap space and active funds for the midcap and smallcap segments.

 

Largecap markets, they say, have become more efficient, making it harder for active largecap funds to outperform. “Active largecap funds have seen declining outperformance in recent years, so index funds or passive funds tracking largecap-oriented indices with a proven long-term record are preferred,” says Jiral Mehta, senior manager, research, FundsIndia.

 

In the largecap space, most of the information is already known to market participants, which makes it difficult to beat the index consistently. The smallcap segment is different. “Smallcap stocks are less researched and more volatile, giving skilled fund managers a better chance of spotting winners early,” says Harsh Vira, chief financial planner and founder, FinPro Wealth.

 

“Actively managed funds offer the potential to generate alpha through stock selection in the smallcap segment,” says Chintan Haria, principal, investment strategy, ICICI Prudential Asset Management Company (AMC).

 

Active funds: Strengths and weaknesses

 

Active smallcap funds have a sound track record. “A reasonable number of these funds have outperformed the benchmark over a market cycle,” says Mehta.

 

Their fund managers can manage risk better by raising or reducing exposure to specific sectors, depending on market conditions. “Active managers can respond to evolving business fundamentals,” says Shweta Rajani, head, mutual funds, Anand Rathi Wealth.

 

A good fund manager can avoid weaker businesses and potential value traps. Active managers can also invest beyond the Nifty Smallcap 250 universe and identify promising businesses that are not yet part of the index.

 

These funds, however, have a few downsides. “Not every active fund manager succeeds in the smallcap space,” points out Vira. Hence, there is no guarantee that the fund an investor chooses will outperform its benchmark. Investors also pay higher fees in active funds, irrespective of whether the fund outperforms.

 

Passive funds: Benefits and limitations

 

A passive strategy gives investors diversified, transparent and cost-efficient exposure to the smallcap segment. “Passive funds are cheaper, simpler and remove the risk of choosing the wrong fund manager,” says Vira.

 

The risk here is that passive funds own every stock in the index, including weaker companies. “A market-cap-weighted smallcap index can carry junk exposure by default,” says Nitin Agrawal, chief executive officer, mutual funds, InCred Money.

 

Passive funds also cannot adjust when valuations become excessive. They have limited ability to respond quickly to changing market conditions.

 

Which route suits you?

 

Experts recommend proven actively managed smallcap funds for the core smallcap allocation. “Active management remains more suitable for the core smallcap allocation because of the inefficiencies and dynamic nature of the segment,” says Rajani.

 

But investors must satisfy a few preconditions. “Investors who can select and monitor fund managers, and who seek the possibility of higher returns, may opt for active funds. On the other hand, those who want a low-cost, hassle-free approach and do not want to worry about manager performance may be better suited to passive funds,” says Vira.

 

The choice, according to him, should depend on whether the investor believes active managers can consistently add value after fees.

 

Checks before investing

 

Investors should first check the expense ratio and tracking error. For ETFs, check liquidity and trading volumes because low liquidity can raise buying and selling costs. Also select funds with a reasonable corpus.

 

Smart-beta option

 

Six smart-beta funds exist in the smallcap space. “Smart-beta smallcap funds apply rules-based factor filters such as momentum, quality, value or a combination over the smallcap universe instead of simply tracking a broad market-cap index,” says Agrawal.

 

These strategies can reduce exposure to weaker companies that occurs when investors choose a plain market-cap-weighted smallcap index.

 

But this option is not devoid of risks. Smart-beta investing remains a relatively new style, with a limited track record across market cycles. These strategies use historical patterns and predefined rules, which may not work in every market cycle. Momentum strategies, for instance, can underperform sharply during sudden trend reversals because they rely on past trends.

 

Factor investing is also cyclical and may underperform for long periods. Rules-based portfolios often lack the flexibility to adapt quickly. “Smart-beta funds also carry the risk of sector or style concentration,” says Rajani.

 

Plain vanilla passive or smart-beta?

 

An ordinary smallcap index fund is suited to investors who want pure, low-cost exposure to the smallcap segment without taking a view on which factor will work.

 

“A smart-beta smallcap fund suits evidence-driven investors who understand factor investing and can accept a different, or sometimes higher, risk profile in, say, a quality or momentum fund,” says Agrawal.

 

Investors should choose smart-beta funds only if they can stay invested during phases when the strategy does not work.

 

Dos and don’ts

 

Commit to a minimum five- to seven-year horizon, as smallcaps usually require patience through multi-year drawdowns. Ensure that total smallcap exposure does not exceed 25 per cent of the equity portfolio.

 

Finally, continue with systematic investment plans (SIPs) during market downturns. 

 

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The writer is a Mumbai-based independent journalist.