Small-cap funds: Does high benchmark overlap lead to poorer returns than active stock selection bets?

Active small-cap funds give fund managers the flexibility to make stock-selection and portfolio-allocation calls with the aim of generating alpha. However, the extent to which funds actually differentiate their portfolios from their benchmarks can vary significantly.

A recent analysis by Value Research highlights this difference by comparing the five small-cap funds with the highest and lowest benchmark overlap, along with their one-year performance.

Benchmark overlap measures the proportion of a fund's stock portfolio that is also present in its benchmark index. A higher overlap indicates that a larger part of the portfolio resembles the benchmark, while a lower overlap suggests greater deviation from the index.

Which small-cap funds have the highest benchmark overlap?

The five funds with the highest overlap had between 26.6% and 32.7% of their portfolios in common with their respective benchmarks.

Within this group, performance varied substantially. Axis Small Cap Fund had the highest overlap of 32.7%, but its returns were not the lowest. Nippon India Small Cap Fund gave the lowest return at 10.6% over the last one year, despite having a lower overlap than Axis Small Cap Fund.

However, Union Small Cap Fund delivered the highest return at 23.3%, despite having an overlap of 26.6%.

This indicates that higher benchmark overlap does not necessarily mean poorer returns than funds where the manager takes more active stock-selection bets.

Which small-cap funds have the lowest benchmark overlap?

At the other end, the five funds with the lowest overlap had just 6.8% to 13.1% of their portfolios in common with their respective benchmarks.

Despite having the lowest overlap of 6.8%, Tata Small Cap Fund gave negative returns over the last one year. This shows that a higher degree of active stock selection does not necessarily translate into higher returns, which is one of the common misconceptions about active funds.

However, Bank of India Small Cap Fund gave the highest return over the last one year, with a benchmark overlap of 12.9%.

What does this mean for investors?

While active funds aim to generate higher returns through stock selection, the data shows that a lower benchmark overlap does not automatically translate into better performance.

For example, Bank of India Small Cap Fund had only 12.9% overlap with its benchmark but delivered the highest return among the 10 funds. However, Union Small Cap Fund, which had a higher benchmark overlap of 26.6%, delivered the second-best return of 23.3%.

This shows that benchmark overlap indicates how differently a fund is positioned from its benchmark, but it does not fully explain the performance of an actively managed fund.

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.