Small-cap mutual fund schemes have been hot for a while, but should new investors jump in?

‘Small is beautiful’ or ‘the bigger the better’—which one do you think has the best value?

Now, imagine the possibility of purchasing a product that has grown to a very large size but still centres around things that are deemed small.

That’s the realm of small-cap funds, which invest primarily in small-cap stocks. Though these stocks are considered small in terms of market capitalisation, such has been the investor appetite for them that a few funds in the segment have become so large that deploying investor money has become a problem, forcing some fund managers to temporarily halt new subscriptions.

To understand why that is the case we need to first tackle a frequently asked question that always surfaces when the benchmark indices scale record highs: What is the outlook on the small-cap universe of stocks, especially when the small-cap barometer has outpaced the benchmarks, the S&P BSE Sensex and the broader Nifty 50? A bunch of fund managers reckon the recent rally and the resulting surge in valuations demand that they take a breather in terms of putting more money into such stocks that often encounter liquidity problems during hefty buy or sell orders.

Consider this: While the Sensex has gained 9.45 per cent so far in 2023, the S&P BSE SmallCap index has rallied 17.50 per cent through July 17. Interestingly, this comes on the back of a 1.80 per cent fall in the small-cap index in 2022, when the Sensex rose nearly 4.5 per cent.

This is noteworthy because many market watchers believe that a sharp increase in the value of small-cap stocks indicates that the rally is nearing its end, even though the Indian stock market is currently receiving strong support in the form of inflows from both foreign and domestic institutional investors.

Now, let’s talk about small-cap mutual fund schemes.

The amount of fresh money pouring into these schemes has reached record highs in the recent past. According to data from the Association of Mutual Funds in India (AMFI), net inflows in small-cap funds hit an all-time high of Rs 5,472 crore in June, up from Rs 3,282 crore in May, while popular equity categories like large-cap funds, flexi-cap funds, equity-linked savings schemes (ELSS) and focussed funds witnessed net outflows during the same period.

Additionally, small-cap funds received cumulative fresh flows of slightly more than Rs 29,500 crore in the 12 months till June 2023, which was again much higher than all other categories of equity schemes. However, that is just one side of the story.

At least two major fund houses, Nippon India Mutual Fund and Tata Mutual Fund, have stopped accepting fresh lump sum investments in their respective small-cap schemes. The reason cited is the huge run-up in the prices of most small-cap stocks that has made their valuations soar, causing fund managers to worry that they are becoming locked in a vicious spiral.

A Vicious Cycle

Low liquidity is a common problem for small-cap stocks, making it challenging for institutional investors like mutual funds (MFs) to buy large quantities of shares. Even if the required quantity is available, a huge order could drive up the price, making the acquisition prohibitively expensive. And, large schemes usually have substantial purchase requirements. Compared to Tata Small Cap Fund’s assets under management (AUM) of nearly Rs 5,250 crore, Nippon India Small Cap Fund’s AUM is around Rs 32,000 crore. Both plans are no longer accepting fresh money through the lump sum route, but they continue to honour current systematic investment plans (SIPs).

“The step was warranted given the recent sharp rally in the small-cap space and increasing investor participation through high-ticket investments. We thought it is in the best long-term interest of investors in the fund for money to arrive in a more calibrated manner,” says Samir Rachh, Fund Manager-Equity, Nippon India Mutual Fund. “Small-cap is a comparatively less liquid space and has high impact cost. In that context, the size of the fund does create its own challenges,” he adds.

Similarly, Anand Vardarajan, Business Head-Institutional Clients, Banking, Alternate Investments & Product Strategy of Tata Asset Management, notes that the fund house’s performance has resulted in robust flows, which have increased cash in hand. Unlike large-cap companies, which typically have plenty of liquidity, small-caps can make it tricky to get the amount needed. “If we still buy, the impact cost goes up and we unwittingly drive up the price,” explains Vardarajan.

According to AMFI, the top 100 stocks by market cap are considered large-caps, while the following 150 are classified as mid-caps. The small-cap market comes next. To put it differently, the largest stock that a small-cap fund could invest in would be the 251st largest company in terms of market capitalisation, in the overall list of listed firms.

“The issue that a lot of large small-cap funds face is daily liquidity with a lot of small-cap stocks having really low average daily volumes. When inflows into small-cap funds increase faster than daily liquidity, as has happened recently, it can become a limiting factor for funds and it will always impact funds with the largest SIP books first,” says Gaurav Rastogi, Founder & CEO of Kuvera, an online wealth management firm.

No Longer Small

At least six small-cap funds have AUM of over Rs 5,000 crore. Nippon India Small Cap Fund is the largest in the country with almost Rs 32,000 crore of AUM as of June 30, according to Value Research. HDFC Small Cap Fund and SBI Small Cap Fund follow with AUMs of over Rs 19,000 crore and Rs 18,700 crore, respectively. Leading fund houses including Axis Mutual Fund, Kotak Mutual Fund, HSBC Mutual Fund, Canara Robeco Mutual Fund, and ICICI Prudential Mutual Fund offer large small-cap fund schemes with an AUM of more than Rs 6,000 crore each, as per data from Value Research. In light of the assets they manage, it is clear that small-cap funds are, in fact, not small.

Even though small-cap funds have the lowest number of schemes (total 24) among the most popular MF schemes in the equities category, they have a cumulative AUM of approximately Rs 1.68 lakh crore as of July 30. This makes them the sixth-largest fund category in the equities segment. Small-cap funds also boast of a huge number of folios, at 12.3 million, almost on par with that of flexi-cap funds (12.8 million), which have the highest AUM of Rs 2.73 lakh crore amongst all categories of equity-oriented MF schemes.

Fund houses typically take pride in their large AUM schemes, but the sheer scale of small-cap funds appears to have presented a management difficulty.

“At times there can be a need to shut a fund. It can depend on a few factors like the size of the fund within its category relative to the available liquidity in a segment like small-cap to build relevant positions,” says Ajit Menon, CEO, PGIM India Mutual Fund.

“It can also depend on the liquidity of the existing portfolio relative to the expected flows, especially outflows. It could also be dependent on valuation. A fund house may feel that the valuations are overstretched to the point where incremental flows, while being accommodated, may not have a good investment experience,” he adds.

It’s a bull market, and small-cap funds are outperforming the rest in terms of returns. In the current calendar year through July 13, small-cap funds have given a category average return of a little more than 15 per cent, higher than that of all other equity-oriented categories, including flexi-cap (9.25 per cent), large-cap (7.82 per cent), mid-cap (12.74 per cent), and multi-cap (11.05 per cent). However, it is frequently argued that past performance does not guarantee future outcomes and that investors in MFs should not base their decisions on the historical returns of a scheme or a category. What does that mean for people who want to use the MF route to invest in the small-cap universe?

The Way Forward

The best piece of advice long-term investors can take right now is to stick with their investments, no matter what the fund houses do. “We are still positive on small-cap as a category. The segment is good from a long-term perspective and offers enough investment opportunities. All we want is more time to deploy funds,” says Vardarajan.

While there is some enthusiasm in the small-cap space, Nippon India’s Rachh, who oversees the country’s largest small-cap fund, believes there will always be attractive investment opportunities. “Currently we are in a sort of euphoria in small-caps. Markets have their balancing mechanisms and that would ensure that there would be better opportunities to deploy funds. Also, the supply of paper is huge, so it will also bring some good opportunities to deploy the flows,” he adds.

Fund managers may seem optimistic from a longer-term perspective, but when equity benchmarks are near historic highs, investors should always proceed with caution. “The 250 small-cap companies in the Nifty SmallCap Index have a total market cap of around Rs 27 lakh crore. If promoter ownership is assumed to be 80 per cent, there would be approximately Rs 5.5 lakh crore in free float. Of that, small-cap funds probably hold around Rs 1.25 lakh crore or about 23 per cent, which is not an alarmingly high ownership in aggregate,” says Rastogi.

“For the larger market and retail [segment], it also becomes an indicator of caution that the small-cap space is so hot that some of the leading funds are having a hard time deploying funds without moving prices significantly. The last time this happened was in mid-2017, before the small-cap index peaked in January 2018,” he explains.

In a recent note, domestic broking major ICICI Direct stated that while small-cap funds have seen significant underperformance in the past few years, if overall markets remain stable, these funds may continue to thrive going forward.

There’s probably still enough steam left to drive markets, especially small-caps, to new heights, but a little bit of prudence never hurt anyone.

@ashishrukhaiyar