Current market context
Small cap equity mutual funds have been a rage with retail investors over the past 3 months. The Nifty Small Cap 250 Index is at its record high. The small cap index has outperformed Nifty 50 by a big margin over the last 3 years (see the chart below) and has continued to outperform if we see recent returns e.g. last 1 month or last three months.
In each of the months of the first quarter of this financial (FY 2023-24), small cap funds attracted the largest net inflows among all actively managed equity mutual fund categories. In April, May and June 2023, small cap funds got net inflows of Rs 2,182 crores, Rs 3,282 crores and Rs 5,471 crores respectively. Small cap inflows constituted nearly 60% of net inflows of actively managed equity fund categories (source: AMFI monthly data, April, May and June 2023). In wake of these large inflows some small cap funds are declining fresh lump sum investments.
In this article, we will discuss whether you should continue to invest in small cap funds.
Source: National Stock Exchange, Advisorkhoj Research, as on 30th June 2023. Disclaimer: Past performance may or may not be sustained in the future
What are small cap funds?
Stocks below the top 250 stocks by market capitalization are classified as small cap stocks. As per SEBI’s mandate, small cap funds must invest at least 65% of their assets in small cap stocks. Small cap stocks usually have high promoter ownership and relatively less ownership by institutional investors compared to large cap and midcap funds. The earnings growth potential of small cap stocks is higher than large and midcap funds. Furthermore, the price discovery of small caps is not as efficient as large caps. Also, the small cap universe with 250+ stocks is bigger than the universe of large caps and midcaps. Due to the above reasons, fund managers of small cap schemes have greater potential of generating higher returns compared to large and midcap funds (see the chart below). If we look at category returns over the past 10 years (see the chart below), you can see that small cap funds outperformed large cap and midcap funds in 7 out of 10 years.
Source: Advisorkhoj Research as on 30th June 2023. Disclaimer: Past performance may or may not be sustained in the future
Why are some small cap funds declining lump sum investments?
You should understand that in equity investments, price and earnings growth are not the only factors; liquidity is a very important factor. Before we discuss liquidity of small cap stocks, let us understand a concept known as free float shares and market cap. Free float shares of a company are the shares owned by the public. Public includes retail, HNI and institutional investors. Free float shares do not include shares owned by promoter, promoter’s family and related parties, management of the company and the Government. Free float market cap is the share price multiplied by the number of free float shares outstanding. In small cap stocks, the free float market cap is a small percentage of total market cap compared to large cap or even midcap stocks. A free float market cap indicates the liquidity of a stock.
What does this mean for small cap funds? If a fund wants to deploy a large amount in a small cap stock with low free float shares, it may drive the price of shares up because the supply of shares is limited. The fund may be forced to buy the shares at a much higher price than what it intended to pay for the shares, especially when share prices are already high. There can also be the problem of over-supply in a volatile market. Suppose there are large scale redemptions, the fund manager may not find enough buyers because the free float market cap is low. Then the fund manager will be faced with the undesirable consequence of having to sell some stocks at very low prices or forced to sell stocks which he / she may not want to sell. In both cases, the interests of investors who remain with the fund are harmed. That is why some small cap funds decline lump sum investments from time to time in certain market conditions.
However, you should not extrapolate this to all small cap funds. Some funds may decline lump sum investments because the fund manager may be sitting on large cash balances and does not see attractive investment opportunities at current levels / valuations without increasing concentration in a few stocks. On the other hand, fund managers of other small cap schemes may find attractive investments even at current levels for new investors and at the same time ensure diversification. You should consult with your mutual distributor to know which small cap funds are declining lump sum investments and which small cap funds are continuing to take lump sum investments.
Is this a good time to invest in small cap funds?
How to invest in small cap funds in these times?
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.