Active vs passive small-cap mutual funds: How wide is one-year return gap? Don't assume index schemes always lag

Small-cap funds are equity mutual funds that are required to invest at least 65% of their assets in small-cap stocks. But these are the rules for active small-cap funds, wherein the fund manager has the flexibility to select stocks and build the portfolio based on the scheme’s investment strategy.

There are also passive small-cap funds, which track an underlying index and seek to replicate its portfolio. According to the rules, index funds or ETFs have to invest at least 95% of their assets in the securities of the underlying index.

The Nifty Smallcap 250 TRI (Total Return Index) is a key benchmark for small-cap funds. A TRI captures both changes in stock prices and dividends. In the last 1 year, the index has delivered 6.39% returns.

Here’s a look at the 1-year returns of the funds in both categories and the schemes that have led their respective groups.

The Trust MF Small Cap Fund delivered the highest 1-year return among the active small-cap funds at 30.04%. All five funds delivered returns above the Nifty Smallcap 250 TRI’s 6.39% return during the same period.

The Edelweiss Nifty Smallcap 250 Index Fund delivered the highest 1-year return among the passive funds at 6.13%.

The other four funds delivered returns between 5.95% and 6.07%. Their returns remained close to the 6.39% return of the Nifty Smallcap 250 TRI, reflecting their passive approach of tracking the underlying index.

Why can active and passive small-cap funds deliver such different returns?

Trust MF Small Cap Fund gave 30.04% returns in the last 1 year, compared with 6.13% for the Edelweiss Nifty Smallcap 250 Index Fund—a gap of 23.91%

The difference in returns can be seen from the way the two funds construct their portfolios.

Trust MF Small Cap Fund, an active fund, held 71 stocks, with 75.99% of its portfolio in small-cap stocks and 24.01% in mid-cap stocks. This gives the fund manager greater flexibility to select stocks and allocate more to particular companies or market-cap segments, within the scheme’s mandate.

However, Edelweiss Nifty Smallcap 250 Index Fund held all 250 stocks of the Nifty Smallcap 250, with 92.73% allocated to small-cap stocks and 7.27% to mid-cap stocks.

These differences in portfolio allocation can lead to a significant difference in returns between active and passive funds, even when they are compared against the same benchmark.

Can passive small-cap funds outperform active funds?

Yes. All the passive small-cap funds delivered positive returns over the last 1 year, but active small-cap funds have shown a much wider range of performance.

For example, HDFC Small Cap Fund fell by 2.34%, while Tata Small Cap Fund delivered just 0.13% returns in the last 1 year. This shows that the performance of active funds can vary considerably depending on the stocks selected and portfolio allocations made by the fund manager.

Disclaimer: This is purely for educational/informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.