Small and mid-cap funds: A trap for investors?

1 NOVEMBER 2017

The financial services industry is not generally one that "serves" its customers.

Instead, it tends to find the best way to serve itself by offering products that may not be suitable to its clients or - even if suitable - the risks are never fully disclosed.

True, there is a generic SEBI disclaimer.

But the SEBI-mandated disclaimers - like disclaimers by regulators around the world - are like factual statements that don't necessarily bring about any behavioural change.

We often hear saints (not religious heads, but saints) advising us to "Live a good life and be a good person because one day you will die."

Well, that does not really result in a better behavioural or business attitude.

We still treat most people with contempt and disrespect - or a desire to extract the maximum out of someone.

This is particularly true of the business honchos who populate the financial services industry.

As a few leading lights of the financial firms have owned up to in a series of past confessions (they see their statements as a beacon of light for others to follow on the path to wealth creation - I view them as confessions of sinners), the leaders of financial firms will serve you whatever "level of spice" you wish to be served.

Their school teachers told them "Don't be too honest".

Anywhere. Anyhow, Anytime. They need to make money.

The "financial" in "financial services" is of paramount importance: the financial profits to the company!

"Service" is what they serve to themselves.

The financial firms believe that the fiduciary responsibility to warn you that excess spice may cause you heartburn - or worse, financial ruin - is not their responsibility.

In the US, despite all the failures of the financial firms to serve their customers, the legislators and regulators have been unable to ensure that looking after clients' capital is a "fiduciary" responsibility.

While the powerful lobby of the lawyers in the US would like to see that change (the opportunity to profit from litigation increases!), the more powerful lobby of the financial firms has ensured that customers are exposed to more extraction.

Investor Education or Investor Eradication?

The example of the craze for mid-cap and small-cap funds in India is interesting.

Most fund houses have sold with great zeal the concept of investing in mid-caps.

The mid-cap and small-cap indices are zooming.

Backed by such powerful images and facts, selling an open-end mid-cap and small-cap fund is as easy as selling candy to an innocent child.

The AuM of these small-cap and mid-cap funds are now significantly larger than in 2013: partly due to market action and partly due to the continuous inflows of the marketing machines willing to give you, the customer, whatever level of spice you wish to have. Whether it will result in heartburn is your problem, not theirs!

The unfettered growth of these small cap and mid cap funds may have a dangerous side -effect to your portfolio because:

  • The mutual fund you invest in may not be able to give you all the money you want at the NAV they declare;
  • In theory, your action of a redemption request - and a collective action of a redemption request from the other investors in the mutual fund you are invested in - may lead to a prolonged period for receiving the money for your redemption request.

I looked at the liquidity of five of the more popular small cap and mid cap funds based on the following assumptions and logic:

  • On any given day, the Fund cannot sell or buy more than 33% of the average daily trading volume of the past one year, of the underlying stocks that it owns;
  • This assumption of 33% is pretty safe in the sense that, if the Fund was to be a buyer or seller of that stock of >33% of that stocks long term average daily volume, the Fund can disproportionately influence the price of that stock by its action of buying or selling;
  • If the price moves too much on "light trading volumes", the NAV may be impacted significantly. Investors look at an NAV as a guide to invest or redeem. Assuming that the markets are surging and the NAV of your mid cap fund starts spurting northwards. You may decide to redeem. If a large number of investors decide to act the same way you do on that specific day, the Fund should be able to liquidate its holdings to pay off all the claims. The declared daily NAV implies it is liquid and "transactable": a transaction can happen at that price. That may not be the case.

The results of this analysis (see Table 1) bring up a few interesting points:

  • Between March 31 2017 and September 30 2017, all the funds underperformed the S&P BSE MidCap Index (this may not be the official benchmark for each of them, but I used one "common" Index);
  • Despite the fact that their NAV grew less than the Index, the AuM grew for all funds, except IDFC - this suggests that they collected more money in this time period;
  • But liquidity of the underlying Top 10 stocks in each of the 5 Funds' portfolios remained at levels that should cause alarm to an investor and should make the regulator question why these Funds are not highlighting the risk of continued relative illiquidity of their portfolios.
Table 1: Your NAV may not be realizable, but your level of spice and heartburn may be!
Fund name (change in AuM) Month ended, 2017 AuM, Rs cr Top Holding, Days Minimum Days Maximum Days
HDFC Midcap Opp March 31 15,734 206 2 206
(13.9%) September 30 17,917 364 6 364
           
IDFC Premier March 31 5,916 65 1 248
(-1.6%) September 30 5,820 13 1 207
           
DSPBR Micro Cap March 31 5,523 155 7 208
(5.1%) September 30 5,803 167 11 240
           
Franklin India Prima March 31 5,389 1 1 158
(11.9%) September 30 6,030 5 1 151
           
Sundaram Select Midcap March 31 4,941 212 3 348
(14.6%) September 30 5,663 510 3 510
           
S&P BSE MidCap Index March 31 14,097      
(9.5%) September 30 15,436      

Source: Personal FN, ACEMF, BSE, NSE

In the case of the HDFC Midcap Opportunity Fund, as of March 31, 2017 their Top Holding in the portfolio was Tube Investments. The Fund owned 72.8 lakh shares worth Rs. 457 crore (2.9% of the Fund's portfolio). The average daily trading volume for Tube Investments was 107,071 shares on the NSE and the BSE. This suggests that this Top Holding of the Fund could take the fund manager 206 days to liquidate in an orderly fashion without causing a disruption in the market price of Tube Investments. The assumption is that the selling by this specific Fund (other HDFC Mutual Funds may own this stock but I am assuming that they don't sell their holdings) should not be more than 33% of the average daily volume of that share for the past one year - as a level of over 1/3rd of the average daily volume may cause a "disruption" in the price pattern of Tube Investments.

Within the Top 10 Holdings of the HDFC Midcap Opportunity Fund, the most liquid stock could be sold in 2 days (Minimum Days) and the least liquid stock would take 206 days (Maximum Days).

By September 30, 2017 the AuM of the Fund has increased by 13.9% (my estimate is that 6.7% due to NAV appreciation and 7.2% due to new units being issued) but the liquidity of the portfolio has deteriorated.

The fund accepted more money by issuing more units and ended up with a portfolio that was less liquid!

The Top Holding will now take 364 days to exit (from 206 days).

The most liquid stock amongst the Top 10 Holdings will take 6 days to sell (from 2 days).

The least liquid stock in the Top 10 Holdings will take 364 days to exit (206).

In both time periods, it seems that the Top Holding was the least liquid stock within the Top 10 Holdings - and would take the longest time to sell.

No safety belt?

If you buy a Maruti car, you would expect that whether you buy the 1st car that rolls off the production line, the 100,000th car or the 4 millionth car that rolls of the production line - it would have the same versatility, the same safety, and the same characteristics, as described in their colourful brochures.

If Maruti cannot deliver a versatile and safe car after the 100,000th car is sold - they will stop selling new cars.

If the 100,001st car is inferior in comfort, safety, speed, or any characteristic important to the performance of a car, then Maruti will halt production.

Not so the manufacturers of products in the mutual fund industry.

You are a willing buyer, they are a willing seller.

The product is hot.

Why will they refuse the next order?

The financial logic to grow AuM is clear.

Larger AuM is larger revenues for the AMCs.

Larger revenues are larger profits.

Larger profits are larger salaries and bonuses for the people working in the AMCs.

This is capitalism: raw and brutal - and at its worst!

The one symbolized by the movie Wall Street where "Greed is Good" is the motto that rules the financial world.

Capitalism, as defined by Adam Smith in his "Wealth of Nations" in 1776 and as envisaged by Sir Jamsetji Tata, was not about maximizing profits but about providing a service and earning a profit - but not any "excess" profit!

The Investor Education money spent on "education" does not warn you about the implicit and explicit hazards of being in a fund that has taken more money in - but retained its characteristics of being illiquid.

What is true for HDFC Midcap Fund is probably true for the other 4 in the list - and probably for the other small-cap and mid-cap funds not in this list! I took the detailed example of HDFC Midcap Fund because it is the largest in this category, not to single it out in any way.

Will many investors redeem simultaneously?

A key assumption in this analysis is that a large number of investors will redeem at once to force the Funds to liquidate a large part of their holdings to honour the redemption requests. Hence, the underlying liquidity of the stocks owned by the mutual funds is important.

Placing a minimum net worth criterion on an AMC is a highly suspect way of ensuring "safety". Big is not innocent. Note that the providers of these more popular and risky large mid cap funds are "big" fund houses with supposedly local or global "institutional" backing!

Risk needs to be controlled at the product level just as it has been done for the valuation of bonds in liquid and bond funds. If the mutual fund industry continues to ignore the risks in its chase of AuM, it will (and must) face the wrath of the regulator - as the industry has witnessed in its wrongful support and promotion of opaque practices on distribution commissions in the past.

Regulations and best practices are designed for stress - for the extraordinary, not the ordinary.

Sadly, in this day and age, the extraordinary happens pretty often!

It has become an ordinary event!

In December 1994, after the Mexican Tequila crisis, we had huge redemptions in the Funds that I managed then - and this taught me to respect liquidity!

The Asian crises in 1997 again caused a sell-off in mid-caps and small-cap stocks and a rout of the NAVs of such mutual funds.

As did the bursting of the tech bubble in 2000 (and the K-10 lafda).

And the SARS crisis in March 2003.

And the Lehman crisis in September 2008.

In August 2013, Ben Bernanke's "twist" and desire to raise interest rates in the USA broke the Indian stock market and the Indian Rupee.

And, in March 2016 - 20 months ago - local investors redeemed nearly Rs 5,000 crore from mutual funds because we had a brief market meltdown in February 2016.

Yes, investors can panic and redeem or cancel their SIPs faster than you can chant the mantra "Mutual funds are subject to market risks; read all scheme related documents carefully."

You must be in a mid-cap or small-cap fund, risk permitting!

Don't get me wrong.

Investors with a risk appetite must have an exposure to small cap and mid cap funds - there are many fund houses with capable managers who have built an enviable track record on such products.

These funds deserve to win investor support.

There is no doubt over the advantage for many investors to have an exposure to small-cap and mid-cap funds.

However, these fund houses need to ensure that greed for AuM - either driven by ignorance or by a desire to chase a higher salary and bonus - does not enhance the illiquidity risk of the trusting investors.

Plus, a darker risk that stares us in the face with these large dominant and illiquid holdings by these funds in less liquid companies is the possibility of manipulation of NAV.

What if, to prop up an NAV, someone has to buy just a small volume of shares to keep the share price of the Top 10 shares at elevated levels?

The NAV will be open to blatant manipulation.

Allegedly the original UTI did prop up stocks and markets, on behalf of various governments and business houses in the 1990's. The end result was a Ponzi-like scheme that imploded.

There was no Unit Trust of India after that and there was no trust in India's capital markets. UTI AMC is a remnant of that meteorite explosion.

The capital markets took a few years to recover from that episode.

After four years of sitting in the penalty box from mis-selling the BRIC nonsense to gullible investors, the mutual fund industry has shown signs of recovery on the back of Prime Minister Modi's election victory in May 2014.

To retain that momentum requires responsible behavior from the mutual fund houses - not a chase for AuM.


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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is Founder of Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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10 Responses to "Small and mid-cap funds: A trap for investors?"

Ananth

Nov 12, 2017

Very informative write up by Mr Ajit Dayal. Liquidity is one of the very (if not the most) important aspect for a small cap or midcap (or for that matter any cap!) stock. If you cannot sell without disruption there is no way we can get the returns that are displayed on the board.

Thanks again Mr Ajit Dayal for this very useful and timely article.

Like 

Sharma

Nov 4, 2017

Article is incisive about the risks faced by MF investors. How does the Fund of Funds(FoF) handle these risks ? I can see that Quantum Equity FoF has exposure to the Fund(s) mentioned in the article. Will FoF also face liquidity problems on redemption ?

Like (1)

Sankar

Nov 3, 2017

Thanks. I never thought that liquidity will have this much effect on NAV and honoring the redemption requests.

Like (1)

Rajat

Nov 2, 2017

Gr8 article. Can you share similar information for large cap funds?

Like (1)

sundaravaradan S

Nov 1, 2017

Hi,

We need a Solution; regarding Investing in Small/Mid Cap MF, by retail investors!! (Irrespective of what MF-Managers do).

Like (1)

mahesh

Nov 1, 2017

Sir, Thank you for explaining the risk in such great details. However, with such huge amount of experience and knowledge, I wonder why Quantum AMC has still not launched a mid-cap fund for those who are willing to take some risks.
ByTheWay, now that you have left Quantum AMC, I was hoping that you would do the Path-To-Profit session at Hyderabad , on 4th November-2017. Any chance?

Mahesh

Like (1)

THANGA NAHARAJAN

Nov 1, 2017

Timely article when the market is at all time high. Excellent explanation with Suitable example. All the best.

Like (1)

P Arulselvan

Nov 1, 2017

Thank you Mr Dayal.
It is always better to hear from 'an insider'.
I also read your previous article: Why I worry.
It is really great to hear 'the other side' from a veteran fund manager, who practiced and still practices his trade. I am an investor in Quantum mutual funds. I am aware that liquidity is one of the criteria for QLTEF to own any stock in its portfolio.
I remember hearing about your ‘liquidity' experience in one of the Paths to Profit from Mr Subramaniam. I was told that as a young fund manager you did well with small-cap stocks and received your performance incentives as well, but when the market turned south, you could not sell and had to sit on huge losses.
Coming from a veteran in the same industry, your articles about the 'other-side' (or the ‘dark side’) is very illuminating to retail investors like me. Thank you for writing such articles. At least it reminds me that the market can also move south in a jiffy.

Like (1)

Rupesh Shah

Nov 1, 2017

AN eye opener article. Thanks for highlighting the hidden risk in Mid cap and small cap fund and risky practice adopted by the AMC. Looking forward to many such insights in future ..

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Dharmesh Shah

Nov 1, 2017

Always refreshing to read Ajit. One of few fund houses keeping investor interest in focus all the times.

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