We all can agree on one point that the bull run we have seen in the past year could have been forecasted by very very few people.
The Bull Run has not been limited to only large-cap stocks rather the mid & small-cap stocks have also seen a really healthy run from March 2020 lows.
This has caused investors to pump a lot of money into the small caps via the vehicle of mutual funds which has caused the size of various small-cap funds to balloon.
As per the data available by AMFI (Association of Mutual Funds in India), the Assets under management in small caps as of 31st March 2020 (just when the virus was taking its early roots in India) was ₹35,832.02 Cr, and soon after we saw a phenomenal bull run and as of 31st May 2021 the Assets under management in small caps stand at ₹80,379.64 Cr.
That’s an increase of 124.323% in AUM just in a span of a little over a year. This certainly is an insane number. Since the last year, the sudden rise in AUM points to one thing in particular that many investors who initially might have been against investing in small caps have dived because they fear that they would miss the high returns (also high risks) that small caps are known for.
In today’s blog, We will discuss the risks of a ballooning small-cap fund and how it can hamper your returns.
First of all, let’s discuss the obvious, we all know the risks that are prevalent for small-cap companies, they often have limited capital, resources and face the risk of being the first to go out of business when a recession or national crisis arrives.
However, since these companies are small they have a large runway for growth and maybe some of these may go on to be large-cap companies someday which in turn means if you identify these stocks correctly in their early stages then you could end up with multi-bagger returns.
Their upside potential is limitless and thus if you as an investor have a long-term horizon and can ride the volatility then you should dedicate some portion of your wealth to Small Cap Mutual Funds.
The one critical aspect that you should take into consideration while analyzing Small cap Funds is the AUM.
WHY IS IT PREFERABLE TO AVOID SMALL-CAP FUNDS WITH LARGE AUM?
The Small-cap universe is very huge, all the companies from the 251st onwards position based on market capitalization, fall under the category of small-cap.
Now you would be thinking that the fund managers have an obvious advantage because he/she has a whole bunch of companies to select from, but you are wrong.
Although the Small-cap universe is huge, the companies that are actually “Investible” are only a handful because a majority of the companies have really bad fundamentals and one other major problem is that majority of the stocks do not have enough liquidity.
To add to that, SEBI has mandated all Small-cap mutual funds to invest a minimum of 65% in small-cap stocks and the rest 35% of the AUM can be spread across large and mid-caps companies as per the discretion of the fund manager.
Now, Place yourself in the position of the fund manager and think about how you would deploy the increasing inflow of money in a segment that only has a handful of investible companies and liquidity problems coupled with a cap on the amount that can be invested in Large & Midcaps. You would have four options:
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1. Deploy the additional cash flow in the existing companies in the fund, increasing concentration risk.
2. Spread your additional cash flows thin in many companies this would lead to dilution of the portfolio and most certainly affect returns, Nippon India Small cap presently has 123 stocks which I believe is an over-diversified portfolio.
3. Stop accepting lump sum deposits and put a cap on SIP amount to keep the quality of the portfolio impact like many MFs (SBI & DSP) have done in the past
4. Deploy the increasing cash flow in a liquid or debt mutual fund until the opportunity arises but again this will also hurt returns.
The most rational approach will be the third one according to me.
A Fund Manager mentioned this to ET Team and I quote “Our small-cap fund is currently seeing substantial flows through monthly SIPs. If not for the concurrent redemptions, absorbing these flows would have been a challenge.”
In simple words, the fund manager meant that the inflows via SIPs were growing rapidly, and had it not been for the simultaneous redemptions taking place it would have been really hard to maintain the quality of the portfolio.
I know it’s hard to imagine a fund manager expressing relief over redemptions but in this space having a fine balance between inflows and outflows is the key to a healthy portfolio. A Small-cap fund whose AUM has been increasing steeply is like a bubble that will burst someday and when it does your returns will be affected heavily.
A Small-cap mutual fund is a very exciting option to venture into and but you need to keep your time horizon as 10 years minimum to see substantial gains.
The AUM of the small-cap fund is also a very important metric to consider before venturing into them, one important point to note is that small-cap funds having very low AUM are also dangerous because in the event of heavy redemptions the fund manager will have to sell the underlying stocks at really low prices because of lack of liquidity in this segment.
The first step could be to pick 5-7 funds and then narrow it down to 3-4 funds that fit your checklist, then you can ascertain the average AUM of the 3-4 narrowed down funds and try to select the fund which has an AUM close to average AUM of the 3-4 funds. Of course after analysing the fundamentals of the fund as well.
To sum it up, one should avoid the funds having really low or high AUMs because both the extremes are not suitable, rather stick to the funds with average AUM in this space.
I would like to remind you to not invest solely based on AUM alone but rather consider this as one of the factors in your checklist to select the right fund.
Do not be tempted to invest in small caps based on returns provided in the last year because it may badly backfire and beware of the risk that the investment carries.
You also have to keep on tracking the fund even after you invest and if you see your funds AUM increasing rapidly in size then it might be time to consider redemption as an option.
If you have any queries or opinions regarding the same, please do let me know in the comment section and I will be happy to help you out.
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