More micro-cap funds are on the anvil: Invest or avoid? Simply Save

Thanks to the rally in micro-cap stocks over the past one year, the smallest market-cap pack has caught the fancy of investors and mutual fund houses.

The value of micro-cap stocks in all the mutual fund schemes has risen from Rs 45,500 crore in September last year to over Rs 60,000 crore currently.

To listen to the podcast, click above. To read the podcast conversation, scroll down.

But first, what are micro-caps?

While large-caps are defined as the 1st to 100th companies in terms of full market capitalisation and mid-caps as the 101st to 250th companies, small-caps are the cohort from 251st company onwards in terms of full market capitalisation. Any company beyond the top 500 is considered a micro-cap.

On the returns parameter, the micro-cap pack has outperformed other market caps in recent times. Over the one-year period, the Nifty 100 Total Return Index (TRI) has gained 10 percent. Compared to this, Nifty Micro-Cap 250 TRI is up 44 percent and Nifty Small-Cap 250 TRI has risen 28 percent.

With such performance, even fund houses are looking to bet on this rally.

In June this year, Motilal Oswal Mutual Fund launched India’s first passive scheme which offers exposure to micro-cap stocks. Now, Bandhan Mutual Fund is looking to launch India’s first active scheme that invests in these stocks.

Also Read | Investing in mutual funds just got easier: All you need is a Visa debit card

Moneycontrol spoke to Nirav Karkera, Head of Research at Fisdom, about what micro-cap valuations are telling us, are fund houses taking on extra risk while venturing deep into the market caps and how funds can manage the risks in micro-cap funds.

Also Read | Mutual fund SIPs are growing, but why do people withdraw so soon?

Here’s a summary of what Karkera said:

• Micro-caps have good opportunities in terms of value creation and at the same time, it can be a value trap. Most of these companies are under-researched. So, to those willing to go the extra mile, do the research and identify really sound businesses, as the micro-cap segment offers tremendous opportunities.
• The valuation of the micro-cap segment may tend to look overvalued at the moment. However, one must understand that conventional ratios may not be applicable to micro-caps. In the micro-cap 250 index, almost a third of the weightage goes to capital goods and financial services. By virtue of these sectors, the valuations of the entire index might reflect euphoria. However, this is not applicable across the board on all micro-caps.
• The survival rate is very low in the micro-cap space. These companies have small market caps and their balance sheets are relatively weaker than their larger counterparts. Also, their ability to weather Black Swan events and macroeconomic headwinds is pretty limited.
• Micro-caps over the longer periods have outperformed most of the other market-cap peers, but one thing that is also very distinct is that drawdowns in these stocks are really steep and they operate in a wide range of volatility.
• For a long period, there was a lot of value that was yet to be unlocked in the large-cap, mid-cap and small-cap segments. Now, there are limited opportunities available in these segments. Therefore, mutual funds are now willing to venture deeper and farther into the micro-cap segment in the quest to hunt for more valuable bets.
• It would be wrong to say that mutual funds are taking on extra risk while venturing into micro-cap stocks. Fund houses have analytical and research capabilities, and the knowledge infrastructure required to take good investment calls. While the volatility could be higher in this segment, it's not necessary that the risk is going to be much higher than the larger counterparts.
• One key challenge in this segment is the lack of liquidity, and the risk of higher impact cost is much enhanced and pronounced. A passive fund can circumvent most of these challenges. On the other hand, an active fund may look to operate with a very long tail, which means diversifying across more and more companies to counter the lack of liquidity in the micro-cap space.
• If a retail investor has a long investment horizon, seven to 10 years, he or she can allocate to micro-cap funds. There's no need for a retail investor to shy away from micro-caps, but there is definitely a need to be calculated about allocation to micro-cap funds.